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China 2030China 2030: Building a Modern, Harmonious, and Creative Society

China 2030: China 2030: Building a Modern, Harmonious, and Creative Society The World Bank Development Research Center of the State Council, C 2 030 the People’s Republic of China hin Ca hin 2 030 Building a Modern, M h onious, and Crea C os The World Bank Development Research Center of the State Council, the People’s Republic of China ISBN 978-0-8213-9545-5 SKU 19545 iety tive ar China 2030 China 2030 Building a Modern, Harmonious, and Creative Society The World Bank Development Research Center of the State Council, the People’s Republic of China The World Bank © 2013 International Bank for Reconstruction and Development / The World Bank and the Development Research Center of the State Council, P. R. China 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 16 15 14 13 This work is a product of the staff of The World Bank and the Development Research Center of the State Council, P. R. China. 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Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. All queries on rights and licenses should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank .org. ISBN (paper): 978-0-8213-9545-5 ISBN (electronic): 978-0-8213-9756-5 DOI: 10.1596/978-0-8213-9545-5 Cover design: Debra Naylor of Naylor Design Library of Congress Cataloging-in-Publication Data has been applied for. Contents Foreword .............................................................. xiii Acknowledgments ....................................................... xv Background to This Research .............................................. xix Executive Summary ...................................................... xxi Abbreviations . ....................................................... xxv Part I Overview China 2030: Building a Modern, Harmonious, and Creative Society . . . . . . . 3 1 China’s Path: 1978–2030 ............................................ 4 2 A New Development Strategy for 2030 .................................. 15 3 Structural Reforms for a Market-Based Economy with Sound Foundations ...... 25 4 Increasing the Pace of Innovation ....................................... 34 5 Seizing the Opportunity of Green Development ............................ 39 6 Equal Opportunity and Basic Security for All ............................. 46 7 Strengthening the Fiscal System and Aligning It with the Evolving Role of Government ................................................. 55 8 Achieving Mutually Beneficial Relations with the Rest of World ............... 60 9 Overcoming Obstacles to Implementing Reforms .......................... 65 china 2 0 3 0 v vi c h i n a 2030 Part II Supporting Reports 1 China: Structural Reforms for a Modern, Harmonius, Creative Society . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Setting the Stage: China’s Past Economic Performance, Key Challenges, and Future Growth Potential ..........................................................79 Promoting Efficiency and Equity through Structural Reform ........................ 85 Strengthening the Fiscal System ...............................................89 Enterprise Sector Reforms .................................................. 103 Financial System Reforms .................................................. 115 Land Policies ............................................................127 Annex 1A Why Did China Grow So Fast? .................................... 140 Annex 1B China’s Industrial Policies: Key Actors and Defining Characteristics ........ 141 Annex 1C Unbalanced and Incomplete Financial System ......................... 143 Annex 1D Experiences of Japan and the Republic of Korea in Financial Liberalization .. 145 Notes ................................................................. 147 References ..............................................................150 2 China’s Growth through Technological Convergence and Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Purpose of the Chapter .................................................... 158 Growth Drivers: Betting on TFP ............................................. 158 Building Technological Capacity ............................................. 162 The Road to Innovation .................................................... 168 Defining Policy Priorities ................................................... 172 Emerging Priorities for Innovation ........................................... 181 Concluding Observations .................................................. 187 Annex 2A Annex Tables .................................................. 188 Notes .................................................................198 References ..............................................................208 3 Seizing the Opportunity of Green Development in China . . . . . . . . . . . 217 Why Green Development? .................................................. 217 Green as a Source of Growth ................................................222 Green Improves the Quality of Growth ........................................232 Factors Favoring and Impeding Green Development in China ......................239 Addressing Concerns on Green Development ................................... 247 The Road toward Green Development ........................................249 Annex 3A Sequencing Actions and Confirming Results .......................... 257 Notes .................................................................264 References ..............................................................265 4 Equality of Opportunity and Basic Security for All . . . . . . . . . . . . . . . . . . 271 Challenges for China’s Social Development ..................................... 274 Equality of Opportunity with Security: Goals and Principles .......................280 Expanding Opportunities and Deepening Human Capital .........................287 Developing a Flexible and Secure Labor Market ................................. 315 c OnTEnTS vii Enhancing Security and Improving the Social Security System ...................... 336 Annex Table 4A Illustrative Sequencing of Hukou and Supporting Reforms ....................................................... 350 Notes ................................................................. 351 References ..............................................................354 5 Reaching “Win-Win” Solutions with the Rest of the World . . . . . . . . . . . 361 The World in 2030 .......................................................367 China’s Integration in Global Markets ........................................377 Global Public Goods ......................................................402 Notes ................................................................. 410 References .............................................................. 414 Boxes O.1 The middle-income trap ..............................................12 O.2 Smart urbanization .................................................23 O.3 Reducing poverty ................................................... 47 1.1 Significant potential remains for further productivity gains through factor reallocation ....................................................... 81 1.2 How fast will China need to grow to achieve high-income status by 2030? ......82 1.3 Where are the largest remaining distortions in product and factor markets? .....87 1.4 F unctional reviews: A tool for designing reforms for a more efficient government ....................................................... 95 1.5 Indicative regulatory framework for subnational government debt .............99 1.6 China’s industrial concentration remains low in most sectors ................106 1.7 Administrative monopoly ...........................................106 1.8 Entry, exit, and “creative destruction” ................................. 107 1.9 I mproving the effectiveness of the state-ownership functions in the financial sector .......................................................... 119 1.10 Establishment of a deposit insurance scheme ............................123 1.11 Historical perspective: China’s land-related policy reforms and emergence of the legal framework ..............................................129 1.12 Legal and policy framework: International perspective ..................... 131 1.13 Land markets: International perspective ................................ 133 1.14 Land institutions: International perspective .............................134 1.15 R ural-urban integration and “linking mechanisms”: Current and emerging issues ........................................................... 135 1.16 Land policies to promote rural-urban integration in Korea .................. 138 1.17 Land valuation and taxation: International perspective .................... 139 3.1 Examples of national green development strategies ........................ 219 3.2 G reen development can help resolve the dilemma of global emission reductions. .220 3.3 Further sectoral benet fi s of green development ...........................224 3.4 Detailed analysis of two industries: Cement and iron and steel ...............227 3.5 Robust growth projected for China’s environmental protection industries ......228 3.6 The relationship between green development and employment ...............229 3.7 China’s “Main Functional Area Development Plan” .......................231 3.8 A “Big Push” model for green growth in poor areas: The case of Hunan .......232 viii c h i n a 2030 3.9 The challenge of China’s water pollution ................................235 3.10 China’s solar photovoltaic (PV) industry ................................ 241 3.11 International fossil fuel subsidies ......................................244 3.12 A lack of competition has held up China’s shale gas exploration ..............246 3.13 Energy efficiency and consumer behavior ...............................252 3.14 Low-carbon urban development in China ...............................255 3A.1 Lessons from international experience on climate policy instruments .......... 261 4.1 Health care coordination in OECD countries ............................309 4.2 Initiatives for public participation in social services ....................... 314 4.3 Lessons from performance-related pay experience for public servants in OECD countries ..................................................326 4.4 Recent innovations in hukou reform ................................... 332 5.1 The Japanese experience with voluntary export restraints ..................382 5.2 FDI and competition in services ...................................... 391 5.3 Japan’s transition to a floating exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 5.4 Lessons of the European experiences with capital account liberalization .......399 Figures O.1 China’s impressive economic performance ................................5 O.2 Savings in China compared to other economies ........................... 11 BO.1.1 Few economies escape the middle-income trap ............................12 O.3 China’s economic challenges ..........................................13 O.4 Urban land has expanded faster than urban population ..................... 31 O.5 The quality of China’s tertiary education system is improving rapidly .......... 37 O.6 Unequal spending on early childhood development across Chinese provinces .... 51 O.7 Pension coverage rate of the active labor force, various countries, mid-2000s ....54 O.8 Local governments: Large expenditure responsibilities, inadequate revenues ..... 58 O.9 T he renminbi is increasingly being used as the currency for cross-border trade settlement ....................................................63 1.1 Cross-country comparison of government expenditures as a share of GDP ...... 93 1.2 Cross-country comparison of tax rates .................................. 95 1.3 Cross-country comparison of government revenue .........................96 1.4 SOEs have declined in relative importance ..............................104 1.5 The rate of return for nonstate firms exceeds that of SOEs .................. 105 1.6 Ownership structure of the banking sector, 2005 ......................... 115 1.7 Financial system structure in comparison, 2009 .......................... 116 1C.1 Select indicators of financial sector size/depth, 2009 ....................... 143 1C.2 Funds raised in the financial system (1993–2009) ......................... 145 2.1 China’s communication infrastructure and mobile networks, 2002–12 ........ 164 2.2 Shanghai R&D Public Service Platform ................................ 175 3.1 Emissions of CO from energy, annually and cumulatively ..................220 3.2 D ecoupling economic growth from carbon emissions worldwide .............221 3.3 Index of innovation in climate change mitigation technologies (1990 = 1) ......223 3.4 Energy intensity of GDP, 1990–2009 ..................................224 3.5 No-regrets options for reducing CO emissions in China, 2030 ..............225 3.6 E stimated energy savings and emissions reduction from installing 79 efficiency technologies in heavy industry, 2005–20 ................................226 c OnTEnTS ix B3.4.1 Comparisons of iron and steel energy intensity ..........................227 3.7 Patent assignee origins for wind power technologies .......................228 3.8 Projected annual Chinese exports of green products and services (2030) .......229 3.9 Services, value added, as a share of GDP (2010) ..........................230 3.10 Environmental and natural resource degradation and depletion, 2008 .........233 3.11 Urban air pollution trends in China, 2003–09 ...........................234 3.12 A verage annual SO and NO concentrations observed for the 10 largest 2 2 cities in Japan and China, 1970–2009 ..................................234 B3.9.1 Wastewater emissions projections (COD), 2005–50 .......................235 3.13 Vulnerability to sea-level rise and storm surges by country, circa 2000 ........238 3.14 E fficiency and CO emissions of coal-fired plants in China and United States .....................................................240 3.15a What emissions growth path should China’s cities take? ....................242 3.15b Which way will China’s transport sector efficiency evolve? .................. 242 3.16 H ousehold water and wastewater tariffs in China’s 10 largest cities compared with other major cities, 2008 ................................ 243 3.17 Direct CO emission intensities of various Chinese industries, 2007 ...........248 3A.1 Indicative sequencing of green development reforms .......................257 3A.2 CO emissions per capita and per unit of GDP, 1990–2009 .................259 3A.3 China’s annual CO emissions under three scenarios, 2010–30 ..............260 3A.4 Coal consumption trends for China under three scenarios, 2011–30 ..........262 4.1 Per capita human capital: national, urban, and rural, 1985–2008 ............ 274 4.2 The evolution of income inequality in China since the start of reforms, 1981–2005 ...................................................... 275 4.3 Global trends in per capita GDP growth and Gini coefficients, 1980s–early 2000s ................................................ 275 4.4 Number and share of population age 60 and over, 1950–2050 ..............277 4.5 Total population and working age population, 1950–2050 .................277 4.6 Number of people with at least one noncommunicable disease, 2010–30 ....... 278 4.7 Projected social spending as a share of GDP .............................285 4.8 P ISA score differences between students with at least one year of preschool education and students without ......................................288 4.9 Prevalence of anemia among children under age five ....................... 289 4.10 International comparison of share of children attending nursery school or kindergarten .....................................................290 4.11 Comparative shares of children attending one-year-only early childhood education programs, 2008 ..........................................291 4.12 D istribution of educational readiness test scores for four- and five- year-olds in China .........................................................291 4.13 Budgetary and total spending per student on early childhood education, by province, 2009 .................................................292 4.14 Comparison of public expenditure on education by level, 2008 ..............294 4.16 T ype of urban schools attended by various subgroups in five Chinese cities, 2005 ...........................................................296 4.15 Spending per capita on education by province, 2000 and 2008 ..............296 4.17 Official promotion rates from junior high school to academic high school, urban and rural, 1990–2006 .........................................297 4.18 International comparison of annual tuition per student in public high schools, late 2000s .............................................298 x c h i n a 2030 4.19 Out-of-pocket and government health spending as share of total health spending, 1997–2010 ...............................................303 4.20 Household health spending as a share of total household income, 2003 and 2008 ...........................................................303 4.21 Comparison indicators on density of general practitioners ..................305 4.22 Pyramid of care model ..............................................306 4.23 Roadmap for PHC modernization .....................................307 4.24 Urban labor force market participation rate among local workers, 1995–2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 4.25 Employment rates of older workers by age, gender, and residence, selected years ..................................................... 318 4.26 International comparison of employment rates by age and gender ............ 319 4.27 Size and composition of informal employment in the urban labor market, various years .....................................................320 4.28 Labor supply by age for rural labor force and rural off-farm work, 2010 ....... 321 4.29 Urban minimum wage adjustments, 1995–2009 .......................... 324 4.30 Tax wedge on average formal sector worker, various countries, 2010 ..........328 4.31 Index of hukou conversion restrictions by city against population and per capita GDP, late 2000s .......................................... 331 4.32 Progressive acquisition of social entitlements for nonlocal workers: An illustrative case ................................................334 4.33 An indicative trajectory for residence permit expansion and hukou unification ....................................................... 335 4.34 Pension coverage rate of active labor force, various countries, mid-2000s ...... 337 4.35 Participation rates for pension programs among working-age adults in urban areas, by gender and residence status ............................. 337 4.36 R ural pension participation: total contributors and as share of rural employed ........................................................ 338 4.37 Pension benet fi s and replacement rates in urban China ..................... 339 4.38 Potential design of long-term pension system ............................343 4.39 Long-term care expenditures in OECD, 2008 ............................346 5.1 Growth trends .................................................... 370 5.2 Growing share of developing countries in global growth ................... 371 5.3 China’s future share in services and historical experiences of other countries ........................................................372 5.4 Labor supply growth will vary greatly among countries .................... 373 5.5 Capital output ratios will further rise, especially in emerging economies ....... 374 5.6 Land prices in China and India will rise sharply .......................... 375 5.7 China’s population will have more low-income people in 2030 than the United States does now ............................................. 378 5.8 China’s share in industrial imports of the world’s 10 largest importers has increased ........................................................ 379 5.9 China’s share in imports of 10 most-protected sectors in the 10 largest importers has increased .............................................380 5.10a China has a large trade surplus in industrial goods with the United States and the European Union ............................................380 5.10b China has a large trade surplus in industrial goods with major trading partners .........................................................380 c OnTEnTS xi 5.11 China’s outward FDI is directed more toward mining, compared with advanced countries’ FDI ............................................387 5.12 Carbon emissions will rise in the baseline scenario ........................403 5.13 Emissions per capita in developing countries are much lower than in advanced countries ................................................404 5.14 State-owned banks dominate China’s banking sector ......................406 5.15 China’s official finance increased sharply in the past decade ................. 408 Tables O.1 China: Projected growth pattern assuming steady reforms and no major shock ....9 1.1 China: Projected growth pattern assuming steady reforms and no major shock ...84 1.2 Size and composition of public expenditures, cross-country comparisons as a share of GDP ......................................................91 1.3 Subnational government finance .......................................92 1.4 S hare of subprovincial governments in total government revenues and spending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 1C.1 Share of banking sector assets by type of bank ...........................144 1C.2 Size of financial sectors or markets as a share of GDP .....................144 2.1 Sources of growth, 1978–2004 ....................................... 160 2.2 Sources of growth by industrial and services sectors, 1978–2004 ............. 160 2A.1 Annual TFP growth rate: Major industries, 1999–2004 .................... 188 2A.2 Top USPTO patents by inventor resident in China, 2005–09 ................ 188 2A.3 W IPO Patent Cooperation Treaty, share of international patents by sector, 2007–09 ........................................................ 189 2A.4 S ector composition of new entrants (legal unit) by established time, Guangdong, Beijing, and Zhejiang, 2008 ...............................190 2A.5 N umber of patents in force in the high-tech industry, by industrial sector and registration status, 2009 ............................................192 2A.6 Innovation inputs and outputs of industrial enterprises in China, by enterprise size, 2009 .............................................192 2A.7 Innovation inputs and outputs of industrial enterprises in the high-tech industry in China, by enterprise size, 2009 ..............................192 2A.8 Foreign direct investment: capital utilized by industry, 2004–09 ............. 193 2A.9 Patent family applications by value and country absolute volume ............. 193 2A.10 Regional and provincial productivity in China ...........................194 2A.11 Domestic patents granted in different provinces in China, 2009 ..............194 2A.12 Innovation inputs and outputs of industrial enterprises in China, 2009 ........ 195 2A.13 Distribution of innovation inputs in China, by type of performer, 2009 ....... 195 2A.14 D istribution of innovation inputs and outputs in high-tech industry in China, by type of performer, 2009 ..........................................196 2A.15 I nnovation inputs and outputs of industrial enterprises in high-tech industry in China, 2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .196 2A.16 Roles of various entities involved in Nation Innovation System ...............197 3.1 Getting to a greener China ..........................................233 3.2 D irect savings and additional co-benet fi s of annual reductions in CO emissions, 2030 ...................................................236 xii c h i n a 2030 3.3 A c omparison of total environmental protection expenditures, 2001–09 .......237 3.4 China’s unique advantages and challenges in green development .............239 3.5 Comparisons of selected indicators for China and developed countries ........240 3.6 Comparative national investment, savings, and consumption rates ............ 241 3.7 Total exploitable renewable energy resources in China ..................... 241 3.8 Key policy packages to achieve green development ........................249 3A.1 Comparison of specific indicators, China vs. high-income OECD ............259 3A.2 Sector-specific recommendations for achieving green growth in China ........262 4.1 Prevalence of overweight and obesity of students ages 7–18 in urban and rural China, 2005 .................................................290 4.2 Hourly wages of migrant and local workers, and share of difference explained by observable characteristics, 2001–10 .................................323 4.3 Share of migrant and local workers with income above minimum wage by gender, 2001–10 ................................................324 4.4 Minimum wage approach and criteria, various economies, end-2000s ......... 327 4.5 Urban social insurance contribution rates in urban China ..................328 4.6 Share of workers with income below minimum SI contribution base (40–60 percent of average wage), 2001–10 ....................................329 5.1 Past and future growth trends ........................................ 369 5.2 China’s trade with developing East Asia differs from that of Sub-Saharan Africa ........................................................... 381 5.3 FDI outflows by emerging markets rose sharply in 2000–09 ................386 5.4 C hina’s exchange rate was relatively stable during the East Asian crisis ........ 393 Foreword hina’s economic performance over World Bank would conduct research drawing the past 30 years has been remark- on lessons from international experience as Cable. It is a unique development well as China’s own successful development success story, providing valuable lessons record, and prepare a strategic framework for other countries seeking to emulate this for reforms that could assist China’s policy success—lessons about the importance making as well as guide future China–World of adapting to local initiative and inter- Bank relations. China’s state leaders wel- regional competition; integrating with the comed and supported the proposal. world; adjusting to new technologies; build- This report, China 2030: Building a ing world-class infrastructure; and investing Modern, Harmonious, and Creative Soci- heavily in its people. ety, represents the results of that work. The In the next 15 to 20 years, China is well- research was organized jointly by China’s positioned to join the ranks of the world’s Ministry of Finance (MOF), the Develop- high-income countries. China’s policy mak- ment Research Center of the State Council ers are already focused on how to change (DRC), and the World Bank. The report the country’s growth strategy to respond to was written and produced by a joint team the new challenges that will come, and avoid from DRC and the World Bank who worked the “middle-income trap.” That is clearly together as equal partners. The team held reflected in both the 11th and 12th Five Year numerous workshops, prepared several stud- Plans, with their focus on quality of growth, ies and background papers, and forged com- structural reforms to harness innovation and mon ideas as well as bonds of friendship and economic efficiency, and social inclusion to mutual respect. A preliminary report was overcome the rural-urban divide and the discussed at a high-level international con- income equality gap. ference held on September 3, 2011, at which The idea behind this study was developed many Chinese and international experts in 2010, at the celebrations for the 30th provided helpful comments and guidance. anniversary of the China–World Bank part- Building on these comments and additional nership. To commemorate that milestone, work commissioned by the team, a confer- former World Bank Group President Robert ence edition of China 2030 was launched at Zoellick proposed to Chinese leaders to work a meeting in Beijing on February 27, 2012. jointly on identifying and analyzing China’s Since that launch, there has been consider- medium-term development challenges look- able interest in this joint study both within ing forward to 2030. Together, China and the China and around the world. This final china 2 0 3 0 xiii xiv c h i n a 2030 version of China 2030 could further enrich First, rethinking the role of the state and the discussions in China and elsewhere, espe- private sector to encourage increased com- cially in middle-income countries that face petition in the economy. Second, encourag- similar issues. ing innovation and adopting an open inno- The report is based on the strong convic- vation system with links to global research tion that China has the potential to become and development networks. Third, looking a modern, harmonious, and creative society to green development as a significant new by 2030. growth opportunity. Fourth, promoting In order to reach that objective, however, equality of opportunity and social protec- China must change its policy and institu- tion for all. Fifth, strengthening the fiscal tional framework. China’s next phase of system and improving fiscal sustainability. development will need to build on its con- Sixth, ensuring that China, as an interna- siderable strengths—high savings, plentiful tional stakeholder, continues its integration and increasingly skilled labor, and the poten- with global markets. tial for further urbanization—and capital- Using the 12th Five Year Plan as a start- ize on external opportunities that include ing point, and the six strategic directions as continued globalization, the rapid growth a policy framework, this report lays out a of other emerging economies, and promising time frame for and sequencing of reforms new technologies. At the same time, China that can take China toward its vision for will need to address a number of significant 2030. We hope that it can provide a practi- challenges and risks, such as an aging soci- cal guide to help China’s policy makers suc- ety, rising inequality, a large and growing cessfully navigate this next phase of China’s environmental deficit, and stubborn external development journey. We also hope that it imbalances. will mark the beginning of another period The report proposes six strategic direc- of fruitful partnership between China and tions for China’s new development strategy. the World Bank. Robert B. Zoellick LI Wei President, 2007–2012 President The World Bank Group Development Research Center of the State Council, P.R.C. Jim Yong Kim President The World Bank Group Acknowledgments his research was organized jointly by and Vikram Nehru, and comprising Junkuo China’s Ministry of Finance (MOF), Zhang, Yongzhi Hou, Guoqiang Long, Shiji Tthe Development Research Center Gao, Yongsheng Zhang, Sen Gong, Wen- of the State Council (DRC), and the World kui Zhang, Pei-Lin Liu, and Changsheng Bank. The report was prepared by a World Chen from DRC, and Ardo Hansson, Sha- Bank and DRC joint team, led by DRC Vice hid Yusuf, Carter Brandon, Philip O’Keefe, Minister Shijin Liu, World Bank Country and Hans Timmer from the World Bank. Director for China and Mongolia Klaus The joint team is grateful to David Bul- Rohland, and World Bank Chief Economist man, Aart Kraay, and Antonio Ollero for for East Asia and the Pacific Region Vikram analytical support and background papers. Nehru. Yukon Huang, advisor to the World Bank President Robert B. Zoellick of the World team, as well as members of the Chinese Bank, Minister Xuren Xie of MOF, and Advisory Board comprising Jinglian Wu, Minsters Wei Li and He Liu of DRC pro- Bin Xia, Fei Feng, Wei Lv, and Yanfeng Ge vided valuable guidance and strong sup- provided helpful advice and suggestions. port throughout. A Chinese internal steer- The team benefited greatly from comments ing committee comprising former Minister by peer reviewers Pieter Bottelier, Bert Hof- of DRC Yutai Zhang, Vice Minister of the man, and Barry Naughton. The team is Ministry of Finance (MOF) Yong Li, Vice also grateful for comments from Fang Cai, Minister of DRC Shijin Liu, Director- Yuanzheng Cao, Yoon Je Cho, Evan Feigen- General of DRC’s General Office Junkuo baum, Shuqing Guo, Motoshige Ito, David Zhang, Director-General of the Interna- Lampton, Lawrence Lau, Jiange Li, Peilin Li, tional Department of MOF Xiaosong Zheng, Dwight Perkins, Il SaKong, Pingping Wang, and Deputy Director-General of the Inter- Yiming Wang, Fuzhan Xie, Shanda Xu, national Department of MOF Shixin Chen, Lan Xue, Weimin Yang, Linda Yueh, and and a World Bank internal steering commit- Yuyan Zhang. Most of those comments were tee comprising Sri Mulyani Indrawati, Lars received at an international conference orga- Thunell, Justin Yifu Lin, Otaviano Canuto, nized by MOF, DRC, and the World Bank in Joachim von Amsberg, James Adams, and Beijing on September 3, 2011. Klaus Rohland, guided this research. The five supporting reports were prepared The overview report was prepared by a under the overall guidance of Shijin Liu, joint team led by Shijin Liu, Klaus Rohland, Klaus Rohland, and Vikram Nehru. china 2 0 3 0 xv xvi c h i n a 2030 Supporting report 1 on structural reforms Wang, Chunfa Wang, Jun Wang, Lan Xue, was prepared by a joint team led by Wenkui and Chunlin Zhang for their most help- Zhang (DRC) and Ardo Hansson (World ful comments and suggestions. In addition, Bank) and included Jianwu He, Louis Kuijs, Jingyue Huang and Bo Lv prepared some of Ulrich Schmitt, Jun Wang, Anbo Xiang, the background company case studies. and Min Zhao. Critical guidance, inputs, Supporting report 3 on green development and advice were provided by Daofu Chen, was prepared by a joint team led by Yongsh- Jianwu He, Shouying Liu, Hongri Ni, Jian- eng Zhang of DRC and Carter Brandon of ing Wei, and Chenghui Zhang (all DRC), the World Bank and comprising Ede Ijjasz, and by Robert Cull, Asli Demirguc-Kunt, Kirk Hamilton, and Chris Sall (World Bank) Juan Feng, Yukon Huang, Guo Li, Haocong and Shouying Liu, Xiaowei Xuan, Yongwei Ren, Tunc Uyanik, Xiaoli Wan, Ying Wang, Zhang, Xiaoming Wang, Jianwu He, and and Luan Zhao (all World Bank). The report Jianjun Dai (DRC). This report also ben- builds on new background papers or notes et fi ed from background papers by Xiaodong prepared by Ehtisham Ahmad (consultant, Wang, Noureddine Berrah (clean energy); fiscal policy), David Bulman (consultant) Victor Vergara, Zhi Liu, Wanli Fang, Holly and Aart Kraay (World Bank, economic Krambeck, Axel Baeumler, Meskerem growth), Yoon Je Cho (consultant, financial Brhane, and Andrew Saltzberg (urban devel- sector), Andrew Hilton and Paul Munro- opment); Lee Travers, Sudipto Sarkar, and Faure (Food and Agriculture Organization, Paul Kriss (water); Sina Johannes (pollution land), Hironori Kawauchi (World Bank, and waste); Luc Christiaensen (agriculture); Japan), Chul Ju Kim (World Bank, Korea), Katrina Brandon (natural resource manage- Ping Li (Landesa, land), and Wenkui Zhang ment); Urvashi Narain and Gordon Hughes and Anbo Xiang (DRC, enterprise sector). (adapting to a changing climate); Kirk Ham- The team benefited from useful discussions ilton and Maryla Maliszewska (simulating a and comments from (in alphabetical order carbon price for China); and Chris Sall (Chi- by surname) Carter Brandon, Loren Brandt, na’s future green export markets, and using Nigel Chalk (IMF), Shixin Chen (MOF), urban quality of life indices to evaluate gov- Klaus Deininger, Peiyong Gao (CASS), ernment performance). Additional comments Sudarshan Gooptu, James Hanson (consul- and guidance from World Bank colleagues tant), Ede Ijjasz-Vasquez, Kang Jia (Institute were provided by Andrew Steer, Ken Cho- for Fiscal Sciences), Il Houng Lee, Lili Liu, mitz, and Michael Toman (peer reviewers), Shangxi Liu, Xiaofan Liu, Millard Long, and Gailius Draugelis, Marianne Fay, Kath- Philip O’Keefe, Thomas Rawski, Elaine ryn Funk, Marea Hatziolos, Dan Hoornweg, Sun, Eric Thun, Rogier van den Brink, Vijay Jagannathan, Abed Khalil, Paul Kriss, Dimitri Vittas, Yan Wang, Li Xu, Shanda Xiaokai Li, Magda Lovei, Gayane Minasyan, Xu, Chunlin Zhang, and Zhuoyuan Zhang. John Roome, Stefanie Sieber, Xuemen Wang, In preparing the report, the team was ably and Yanning Wang. Comments from DRC supported by Jianqing Chen, Yan Wang, and other reviewers were provided by Zhi- and Shanshan Ye. gang Chen, Fei Feng, Ross Garnaut, Stephen Supporting report 2 on innovation was Howes, Carlo Jarger, Kejun Jiang, Nick John- prepared by a joint team led by Shiji Gao stone, Frank Jotze, Hongri Ni, Jiahua Pan, of DRC, and Shahid Yusuf of the World Ye Qi, Heling Shi, Fangfang Tang, Simon Bank and comprising Zhiyan Sun, Jietang Upton, Jinzhao Wang, Yi Wang, Yiming Tian, Xiaowei Xuan and Yongwei Zhang Wei, Ming Xu, Qian Ye, and Xinye Zheng. from DRC, and Luan Zhao, Lopamudra Zijing Niu and Hua Zhu (World Bank), Jian- Chakraborti, and Rory Birmingham from the peng Chen and Haiqin Wang (DRC) pro- World Bank. We thank Hamid Alavi, Cong vided excellent support throughout. Cao, Mark Dutz, Xin Fang, Zhijian Hu, Gary Supporting report 4 on social develop- Jefferson, Yuan Ma, Jamil Salmi, Changlin ment was prepared by a joint team led by acknOwlEdgmEnTS xvii Sen Gong (DRC) and Philip O’Keefe (World (voluntary export restraints), Jin Fang (cross- Bank) and comprising Dewen Wang (World border investment), Jianwu He (growth Bank) and Liejun Wang (DRC). The team prospects), Gang Lv (foreign trade), Maryla also included Jin Song (World Bank), and Maliszewska (forecasts for the global econ- Changsheng Chen, Yang Su, and Dong Yu omy and the scenarios for the impact of cli- (DRC). The Director-General of DRC’s mate change), Aaditya Mattoo (trade), Fran- social development research department, cis Ng (trade), William Shaw (main author), Yanfeng Ge, provided constructive com- Dominique van der Mensbrugghe (forecasts ments for the report. It benefited from for the global economy and the scenarios for background papers by Carl Mason and the impact of climate change), Lucio Vinhas Quilin Chen (social spending modelling); de Souza (international banking regula- Toomas Palu (primary health care); Sen tion), Hongqing Xu (foreign aid), and Lip- Gong and Dong Yu (citizen participation); ing Zhang (opening of the financial sector Liejun Wang and Sen Gong (doctor and and internationalization of RMB). Jin Fang teacher pay), Scott Rozelle (human capi- helped coordinate the revision for this sup- tal); Kin Bing Wu, Christine Boscardin, porting report. Yongsheng Zhang provided and Peter Goldschmidt (education); Fang important suggestions on climate change Cai, Yang Du, and Meiyan Wang (labor issues. We thank Jiyao Bi, Qisheng Lai, market overview, and labor market insti- Hong Song, Youfu Xia, Xiangchen Zhang, tutions); John Giles, Dewen Wang, and and Xiaoji Zhang for their helpful com- Wei Cai (labor supply and retirement); ments and suggestions. Excellent data work Dewen Wang and Philip O’Keefe (hukou); and other inputs were provided by Yueqing Sen Gong and Liejun Wang (hukou) John Jia, Sergio Andres Kurlat, Jose Alejandro Giles and Dewen Wang (social security); Quijada, and Sachin Shahria. The team also and Laurie Joshua (aged care). The team benefited from excellent support provided also benefited from comments from Tamar by Maria Hazel Macadangdang and Rosalie Manuelyan-Atinc, Arup Banerji, Eduardo Marie Lourdes Singson. Velez Bustillo, Fang Cai, Gong Chen, Ariel Pei-Lin Liu, Changsheng Chen, Wei Xu, Fiszbein, Gerard La Forgia, Emmanuel Xian Zhuo, and Ting Shao thoroughly Jimenez, John Langenbrunner, Peilin Li, reviewed and proofread the Chinese version Xiaoyan Liang, Albert Park, Hainan Su, of the overview report and all supporting Adam Wagstaff, Liping Xiao, Xiaoqing Yu, reports under the guidance of and with per- Li Zhang, and Bingwen Zheng. The team sonal involvement of Shijin Liu. is grateful to the Korea Development Insti- Coordination teams led by Yongzhi tute and Japan-China Economic Association Hou, Shixin Chen, Elaine Sun, and Shiji for making arrangements for DRC study Gao and comprising Chunquan Yin, Wei tours in Korea and Japan, respectively, and Wang, Licheng Yao, Weijie Liu, Jiangnan to local Development Research Centers of Qian, Yanning Wang, Yunzhong Liu, Zhi- Chengdu and Nanjing, and the Hangzhou yan Sun, Xian Zhuo, Guangqin Luo, and Government for joint field visits and meet - Li Li provided strong support for the suc- ings. Finally, the team is grateful for assis- cessful completion of the study. Chunquan tance in preparing the document from Limei Yin helped organize a series of important Sun and Tao Su. meetings, while Yi Li, Lihui Liu, Hao Dong, Supporting report 5 on China and Hui Han, and Li Zhu helped in communica- the global economy was prepared by a tions, coordination, and other ad hoc tasks. joint team led by Guoqiang Long of DRC Tianshu Chen of the World Bank served as and Hans Timmer of the World Bank and interpreter at innumerable meetings, par- comprising Dilek Aykut (service sector ticipated in the translation of the report, FDI), Charles Blitzer (renminbi), Deborah and organized and coordinated the trans- Brautigam (official finance), Allen Dennis lation work. The World Bank’s Elaine Sun, xviii c h i n a 2030 Kathryn Funk, and Li Li managed coordi- Ministry of Human Resources and Social nation and production of the English edi- Security, Ministry of Land and Resources, tion. The team is grateful to Patricia Kata- Ministry of Environmental Protection, Min- yama and Susan Graham of the World istry of Housing and Urban-Rural Develop- Bank’s Office of the Publisher for the edit - ment, Ministry of Agriculture, Ministry of ing and layout of the English edition. The Commerce, Ministry of Health, National International Department of MOF, the Gen- Population and Family Planning Commis- eral Office and International Department of sion, The People’s Bank of China, State- DRC, and the World Bank provided support owned Assets Supervision and Administra- in organizing numerous conferences, discus- tion Commission, State Administration of sion meetings, small seminars, and inter- Taxation, National Bureau of Statistics, national field study trips throughout this State Intellectual Property Office, China research. Banking Regulatory Commission, National This research also benefited enormously Council for Social Security Fund, National from comments and suggestions from Chi- Energy Administration, State Administra- nese ministries and local governments, tion of Foreign Experts Affairs, as well as including Ministry of Foreign Affairs, governments of Beijing, Jilin, Heilongjiang, National Development and Reform Com- Shanghai, Jiangsu, Anhui, Henan, Guang- mission, Ministry of Education, Ministry of dong, Chongqing, Shaanxi, Gansu, and Xin- Science and Technology, Ministry of Indus- jiang Uygur Autonomous Region. The joint try and Information Technology, Ministry research team is grateful for all their com- of Public Security, Ministry of Civil Affairs, ments and suggestions. Background to This Research his research was conducted by a joint high-level international seminar held at the research team with experts from the Diaoyutai State Guesthouse, both renowned T World Bank and China, the first time domestic and international experts as well as such research has been conducted in the his- leaders of China’s government departments tory of cooperation between the two. The and high ranking executives of China’s enter- research was organized by China’s Minis- prises commented on the draft and raised try of Finance, the Development Research many critical and constructive ideas. The Center of the State Council (DRC), and the team also asked for opinions and sugges- World Bank. The research work and report tions of relevant central government depart- writing was undertaken by a joint team from ments and local governments during differ- the World Bank and the DRC. ent phases of the project. The team revised The joint team formally launched the the report in line with these comments and research at its first working-level seminar suggestions and held a series of special semi- held at Fragrant Hills in Beijing on Novem- nars to address some prominent issues. The ber 23–26, 2010. The seminar set the vision final report managed to reflect many of these of the research as building a modern, har- diverse views, but without losing its focus monious, and creative high-income society and realism. in China by 2030. Five research groups were Needless to say, the research was challeng- established to study the subjects of structural ing. This was the first time that joint research reforms, innovation, green growth, social was conducted by experts from the World development, as well as China and the world. Bank and China, who approached issues Over the following year, Chinese and foreign from different vantage points, held beliefs experts wrote background reports and jointly shaped by different experiences, and used held a dozen seminars. The experts from the different ways of organization and coordina- World Bank and the DRC also held working- tion. Moreover, China’s challenge over the level seminars, conducted interviews and field next two decades will be nothing short of his- research in relevant government agencies, cit- toric—taking 1.3 billion people from middle- ies, rural areas, and enterprises in China, and to high-income status with the backdrop of visited countries like Indonesia, Republic of an ongoing global financial crisis. While the Korea, and the Philippines. After finishing research was more difficult than expected, the first draft of the research report, the team it was always stimulating and occasionally solicited opinions from many experts. At a fun. It was a good opportunity for sharing china 2 0 3 0 xix xx c h i n a 2030 knowledge and experience, conducting joint debate helped in converging viewpoints and analysis, and learning from Chinese and developing a common understanding. Finally, international experts of different persuasions. shared objectives and mutual respect between The research was a relentless process of iden- the Chinese and World Bank experts, their tifying and discussing problems, deepening professionalism, and their effective collabo- understanding, and attempting to bring for- ration ensured that the research work went ward creative ideas. Second, all members of smoothly. Hopefully, experience from this the team approached the work with an open research will pave the way for more coop- mind, and solicited opinions and sugges- erative undertakings between China and the tions from experts inside and outside China World Bank in the future. to push the discussions forward. Hours of Executive Summary y any standard, China’s economic per- fundamental shift in the country’s strategy. formance over the last three decades After more than 30 years of rapid growth, Bhas been impressive. GDP growth aver- China has reached another turning point in aged 10 percent a year, and over 500 million its development path when a second strategic, people were lifted out of poverty. China is and no less fundamental, shift is called for. now the world’s largest exporter and manu- The 12th Five Year Plan provides an excellent facturer, and its second largest economy. start. This report combines its key elements Even if growth moderates, China is likely to design a longer-term strategy that extends to become a high-income economy and the to 2030. More important, it focuses on the world’s largest economy before 2030, not- “how,” not just the “what.” Six important withstanding the fact that its per capita messages emerge from the analysis: income would still be a fraction of the aver- age in advanced economies. First, implement structural reforms to But two questions arise. Can China’s strengthen the foundations for a market- growth rate still be among the highest in the based economy by redefining the role of gov - world even if it slows from its current pace? ernment; reforming and restructuring state And can it maintain this rapid growth with enterprises and banks; developing the private little disruption to the world, the environ- sector; promoting competition; and deepen- ment, and the fabric of its own society? ing reforms in the land, labor, and financial This report answers both questions in the markets. As an economy approaches the affirmative, without downplaying the risks. technology frontier and exhausts the poten- By 2030, China has the potential to be a mod- tial for acquiring and applying technology ern, harmonious, and creative high-income from abroad, the role of the government society. But achieving this objective will not and its relationship to markets and the pri- be easy. To seize its opportunities, meet its vate sector needs to change fundamentally. many challenges, and realize its development While providing relatively fewer “tangi- vision for 2030, China needs to implement a ble” public goods and services directly, the new development strategy in its next phase government will need to provide more intan- of development. The reforms that launched gible public goods and services like systems, China on its current growth trajectory were rules, and policies, which increase produc- inspired by Deng Xiaoping, who played an tion efficiency, promote competition, facili - important role in building consensus for a tate specialization, enhance the efficiency china 2 0 3 0 xxi xxii c h i n a 2030 of resource allocation, protect the environ- will need to focus on increasing the techni- ment, and reduce risks and uncertainties. cal and cognitive skills of university gradu- In the enterprise sector, the focus will ates and building a few world-class research need to be further reforms of state enterprises universities with strong links to industry; fos- (including measures to recalibrate the role of tering “innovative cities” that bring together public resources, introduce modern corpo- high-quality talent, knowledge networks, rate governance practices, such as separating dynamic firms, and learning institutions, and ownership from management, and implement allow them to interact without restriction; gradual ownership diversification where nec - and increasing the availability of patient risk essary), private sector development and fewer capital for private startup firms. barriers to entry and exit, and increased com- petition in all sectors, including in strategic Third, seize the opportunity to “go green” and pillar industries. In the financial sector, through a mix of market incentives, regula- it would require commercializing the banking tions, public investments, industrial policy, system, gradually allowing interest rates to be and institutional development. Encouraging set by market forces, deepening the capital green development and increased efficiency of market, and developing the legal and supervi- resource use is expected to not only improve sory infrastructure to ensure financial stabil - the level of well-being and sustain rapid ity and build the credible foundations for the growth, but also address China’s manifold internationalization of China’s financial sec - environmental challenges. The intention is tor. In the labor market, China needs to accel- to encourage new investments in a range of erate phased reforms of the hukou system to low-pollution, energy- and resource-efficient ensure that by 2030, Chinese workers can industries that would lead to greener develop- move in response to market signals. It also ment, spur investments in related upstream needs to introduce measures to increase labor and downstream manufacturing and services, force participation rates, rethink wage policy, and build international competitive advantage and use social security instruments (pensions, in a global sunrise industry. These policies health, and unemployment insurance) that are have the potential to succeed, given China portable nationwide. Finally, rural land mar- many advantages—its large market size that kets need to be overhauled to protect farmer will allow rapid scaling up of successful tech- rights and increase efc fi iency of land use, and nologies to achieve economies of scale and policies for acquisition of rural land for urban reduced unit costs; a high investment rate that use must be thoroughly overhauled to prevent will permit rapid replacement of old, ineffi - urban sprawl, reduce local government depen- cient, and environmentally damaging capital dency on land-related revenues, and address a stock; its growing and dynamic private sector frequent cause of complaint from farmers. that will respond to new signals from govern- ment, provided it gets access to adequate lev- Second, accelerate the pace of innovation els of finance; and a relatively well-developed and create an open innovation system in research and development infrastructure that which competitive pressures encourage Chi- can be harnessed to reach and then expand nese firms to engage in product and pro- the “green” technology frontier. cess innovation not only through their own research and development but also by par- Fourth, expand opportunities and promote ticipating in global research and development social security for all by facilitating equal networks. China has already introduced a access to jobs, finance, quality social services, range of initiatives in establishing a research and portable social security. These policies and development infrastructure and is far will be critical in reversing rising inequality, ahead of most other developing countries. Its helping households manage employment-, priority going forward is to increase the qual- health-, and age-related risks, and increasing ity of research and development, rather than labor mobility. China’s relatively high social just quantity. To achieve this, policy makers and economic inequality (some dimensions E x E cu T iv E S u mm ar y xxiii of which have been increasing) stems in large will be able to benefit from further special - part from large rural-urban differences in ization, increased investment opportunities access to jobs, key public services, and social and higher returns to capital, and a mutually protection. Reversing this trend requires beneficial flow of ideas and knowledge. As a three coordinated actions: delivering more key stakeholder in the global economy, China and better quality public services to under- must remain proactive in resuscitating the served rural areas and migrant populations stalled Doha multilateral trade negotiations, from early childhood to tertiary education advocate “open regionalism” as a feature institutions and from primary health care to of regional trading arrangements, and sup- care for the aged; restructuring social secu- port a multilateral agreement on investment rity systems to ensure secure social safety o fl ws. Integrating the Chinese financial sector nets; and mobilizing all segments of soci- with the global financial system, which will ety—public and private, government and involve opening the capital account (among social organizations—to share responsibili- other things), will need to be undertaken ties in financing, delivering, and monitoring steadily and with considerable care, but it will the delivery of social services. be a key step toward internationalizing the renminbi as a global reserve currency. Finally, Fifth, strengthen the fiscal system by mobi - China must play a central role in engag- lizing additional revenues and ensuring local ing with its partners in multilateral settings governments have adequate financing to to shape the global governance agenda and meet heavy and rising expenditure respon- address pressing global economic issues such sibilities. Many of the reforms proposed in as climate change, global financial stability, this development strategy—enterprise and and a more effective international aid archi- financial sector reforms, green development, tecture that serves the cause of development equality of opportunity for all—have impli- in poor nations less fortunate than China. cations for the level and allocation of public expenditures. Over the next two decades, the * * * agenda for strengthening the fiscal system will involve three key dimensions: mobiliz- These six priority reform areas lay out ing additional fiscal resources to meet rising objectives for the short, medium, and long budgetary demands; reallocating spending term, and policy makers need to sequence the toward social and environmental objectives; reforms within and across these areas appro- and ensuring that budgetary resources avail- priately to ensure smooth implementation able at different levels of government (central, and to reach desired outcomes. A successful provincial, prefectural, county, township, outcome will require strong leadership and village) are commensurate with expenditure commitment, steady implementation with a responsibilities. Without appropriate fiscal determined will, coordination across minis- reforms, many of the other reform elements tries and agencies, and sensitive yet effective of the new development strategy would be management of a consultation process that difficult to move forward. will ensure public support and participation in the design, implementation, and oversight Sixth, seek mutually beneficial relations with of the reform process. And since the global the world by becoming a proactive stake- economy is entering a dangerous phase holder in the global economy, actively using and China itself will be transitioning from multilateral institutions and frameworks, middle-income to high-income status, the and shaping the global governance agenda. government will need to respond to a variety China’s integration with the global economy of risks, shocks, and vulnerabilities as they served it well over the past three decades. arise; in doing so, it must hold fast to the By continuing to intensify its trade, invest- principle that policy responses to short-term ment, and financial links with the global problems should uphold, not undermine, economy over the next two decades, China long-term reform priorities. Abbreviations 5YP Five Year Plan ALTC Aged and long-term care APEC Asia Pacific Economic Corporation BITs Bilateral investment treaties BRICS Brazil, the Russian Federation, India, China, and South Africa CBRC China Bank Regulatory Commission CCS Carbon capture and sequestration CCT Conditional cash transfer CO Carbon dioxide CPC Communist Party of China CPCC Communist Party Central Committee CPI Consumer Price Index CSRC China Securities Regulatory Commission DRC Development Research Center of the State Council, P. R. China ECDE Early childhood development and education EFTA European Free Trade Association EU European Union FDI Foreign direct investment GATT General Agreement on Tariffs and Trade GDP Gross domestic product GEM Growth enterprises market GNI Gross national income GPT General purpose technologies HRS Household responsibility system ICOR Incremental capital-output ratios ICT Information and communication technology IMF International Monetary Fund china 2 0 3 0 xxv xxvi c h i n a 2030 IT Information technology KBA Key biodiversity areas KWh Kilowatt hour LED Light-emitting diode LFPR Labor force participation rate M&A Mergers and acquisitions MFN Most-favored nation MIIT Ministry of Industry and Information Technology MSME Micro, small, and medium enterprises NBSC National Bureau of Statistics of China NBFI Nonbank financial institutions NDRC National Development and Reform Commission NO Nitrous oxide NPL Nonperforming loan OECD Organisation of Economic Co-operation and Development OPEC Organization of Petroleum Exporting Countries PBC People’s Bank of China PISA Programme for International Student Assessment PM Small particulate matter PPP Purchasing power parity PSU Public service unit R&D Research and development ROE Return on equity RMB Renminbi SAMC State asset management company SASAC State Owned Assets Supervision and Administration Commission S&T Science and technology SFI State financial institutions SME Small and medium enterprise SO Sulphur dioxide SOE State-owned enterprise TCE Tons of coal equivalent tCO Tons of CO 2 2 TFP Total factor productivity TVET Technical and vocational education and training UDIC Urban Development Investment Corporations UN United Nations UNEP United Nations Environment Programme VAT Value added tax WIPO World Intellectual Property Organization WTO World Trade Organization Part I Overview China 2030: Building a Modern, Harmonious, and Creative Society China 2030: Building a Modern, Harmonious, and Creative Society Introduction From the early 1500s until the early 1800s, And can it maintain this rapid growth with China’s economy was the world’s largest. little disruption to the world, the environ- By 1820, it was one-fifth again as big as ment, and the fabric of its own society? We Europe’s and accounted for a third of world answer “yes” to both, but only if China tran- gross domestic product (GDP). But the next sitions from policies that served it so well in two centuries were tumultuous for China. the past to ones that address the very differ- The country experienced catastrophic ent challenges of a very different future. decline between 1820 and 1950 and then, This overview, followed by five sup - starting in 1978, meteoric rise (Maddison porting reports, identifies these challenges 2001). Today, China is once again among of tomorrow, points to key choices ahead, the largest economies of the world, having and recommends not just “what” needs overtaken Japan in 2010. Its economy is to be reformed, but “how” to undertake now second only to that of the United States the reforms. The overview is divided into (third, if the European Union [EU] is counted nine chapters. The first chapter examines as one economy), and it is the world’s largest the characteristics of China’s development manufacturer and exporter. The East Asian since 1978; considers future opportuni- miracle may have lost some of its luster after ties, challenges, and risks; and describes a the financial crisis of 1997–98, but China’s vision of China in the year 2030. The sec- performance continues to impress. Even if ond chapter maps a new strategy that will China grows a third as slowly in the future realize this vision, focusing on the key compared with its past (6.6 percent a year on choices ahead for China to sustain rapid average compared with 9.9 percent over the economic and social development and past 30 years), it will become a high-income become a modern, harmonious, and cre- country sometime before 2030 and outstrip ative high-income society before 2030. the United States in economic size (its per Chapters 3–8 elaborate on each of the six capita income, however, will still be a frac- pillars of the new strategy: consolidating tion of that in advanced countries). If China China’s market foundations; enhancing achieves this milestone, it will have avoided innovation; promoting green development; the “middle-income trap” by traversing the ensuring equality of opportunity and social seemingly impossible chasm between low- protection for all; strengthening public income and high-income status within a gen- finances; and achieving mutually benefi- eration and a half—a remarkable achieve- cial win-win relations between China and ment for any country, let alone one the size the rest of the world. The ninth and final of China. chapter addresses implementation chal- But two questions arise. Can China’s lenges, including the sequencing of proposed growth rate still be among the highest in the reforms and overcoming obstacles that are world even if it slows from its current pace? likely to emerge. china 2 0 3 0 3 4 c h i n a 2030 Chapter 1 China’s Path: 1978 to 2030 within the broader context of reform priori- Unique Factors behind China’s ties. By introducing market-oriented reforms Economic Success in a gradual, experimental way and by pro- Over the past three decades, China’s two his- viding incentives for local governments, the toric transformations, from a rural, agricul- country was able to discover workable tran- tural society to an urban, industrial one, and sitional institutions at each stage of develop- from a command economy to a market-based ment. One key feature of these reforms was one, have combined to yield spectacular their “dual-track” nature—supporting state- results. Not only did economic growth soar, owned firms in old priority sectors while lib - but the poverty rate fell from more than 65 eralizing and encouraging the development of percent to less than 10 percent as some 500 private enterprises (Lin 2012). The economy million people were lifted out of poverty, and was allowed to “grow out of the plan” until all the Millennium Development Goals have the administered material planning system been reached or are within reach. Although gradually withered. As a result of continuous growth rates differed across China, growth and decentralized trial-by-error exploration, was rapid everywhere. Indeed, if mainland institutional arrangements evolved as new China’s 31 provinces were regarded as inde- and different challenges needed resolution. pendent economies, they would be among Indeed, different localities often adopted the 32 fastest-growing economies in the their own unique institutions tailored to their world (figure O.1). Such rapid growth has specific situations. been accompanied by many other achieve- ments: for example, 2 of the world’s top 10 Balancing growth with social and macro- banks are now Chinese; 61 Chinese compa- economic stability. The difficult economic nies are on the Global Fortune 500 list; and situation at the start of reforms in 1978 China is home to the world’s second-largest made economic growth an urgent priority. highway network, the world’s 3 longest sea Early reform successes quickly transformed bridges, and 6 of the world’s 10 largest con- this priority into a national objective that tainer ports. The country has also made was effectively used to mobilize all quarters large strides in health, education, science, of society—individuals and firms as well as and technology, and is quickly closing the local governments—to focus their collective gap on all these fronts with global leaders. efforts on economic development. The gov- Many unique factors lie behind China’s ernment employed a mix of fiscal, adminis - impressive growth record, including the trative, and employment policies to maintain initial conditions of the economy in 1978 social stability during a period of rapid eco- that made it particularly ripe for change. nomic and structural change. This was no The spark came in the form of agricultural mean achievement, given the need to employ reforms, including the household responsi- an additional 9 million new entrants into the bility system that foreshadowed sustained labor force each year while also absorbing reforms in this and other areas over the next workers affected by policy shifts (such as the 30 years. To summarize, key features of the 1998 reforms of state-owned enterprises, or reforms included: SOEs), frictional unemployment, and occa- sional external economic shocks. Pragmatic and effective market-oriented Rapid growth and structural change also reforms. China’s uniqueness among devel- presented macroeconomic challenges. The oping countries is not what it did to achieve economy experienced occasional bouts of success, but how it did it. China adapted a serious inflation, such as in the late 1980s and strategy known as “crossing the river by feel- early 1990s. But macroeconomic stability was ing stones,” which encouraged local govern- effectively restored through a combination of ments to undertake bold pilot experiments traditional monetary and fiscal policies, as over vie w 5 FIg Ur E O.1 China’s impressive economic performance a. China’s rapid, broad-based growth . . . b. . . . has made it the second-largest economy in the world . . . 6,000 5,000 Chinese provinces (31) 4,000 8 3,000 Japan other countries (182) 2,000 1,000 China –2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: NBSC 2010; World Bank 2011b. Source: NBSC 2010; World Bank 2011b. c. . . . the world’s largest exporter . . . d. . . . and the world’s largest manufacturer 1.8 2,500 1.6 2,000 1.4 United States 1.2 1,500 1.0 United States 0.8 China 1,000 0.6 China 0.4 0.2 0.0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1990 1995 2000 2005 2010 2015 Source: NBSC 2010; World Bank 2011b. Source: UNSD 2010. well as administrative means when neces- and regional differences meant that local sary. As a result, the authorities were broadly governments could experiment with and successful in keeping inflation low through - champion specific reforms suited to their out the period and protecting the rural and circumstances, while operating within the urban poor from relative price increases in parameters established by central authori- key necessities. ties. Officials were rewarded for deliver- ing key reform goals: growth, foreign direct Interregional competition. China built on investment (FDI), employment, and social its strong local governments at various levels stability. The resulting competition between by allowing them to compete in attract- local governments and regions was fierce— ing investment, developing infrastructure, and became a strong driver of growth—far and improving the local business environ- beyond the expectations of the authorities. ment. Decentralization policies, including fiscal reforms in 1994 (which significantly Domestic market integration. A key ele- increased resource transfers from the cen- ment of the reforms was the dismantling of tral government), gave subnational govern- regional barriers to the movement of goods, ments the incentives and the resources to labor, and capital and the establishment of aggressively pursue local development objec- a single national market. Major infrastruc- tives. Increased factor mobility meant that ture investments connecting regions and resources flowed to jurisdictions most sup - the interior to the coast helped. A large and portive of growth. Finally, China’s vast size integrated domestic market allowed firms to US$ (trillions) Annual average GDP growth, 1980–2010 (%) Manufacturing GDP GDP (US$ billions, current prices) (US$ billions, current prices) 6 c h i n a 2030 achieve scale economies, and the large varia- will be very different over the next 20 years tion in income levels and consumption pat- compared with the past 30, not only because terns across the country gave their products a China and other emerging markets have fun- longer life cycle. damentally reshaped the global economy— a trend that was accelerated by the recent Steady integration with the global econ- global financial crisis—but also because omy. With the establishment of special new global challenges and opportunities are economic zones, Deng Xiaoping’s remarks emerging that will significantly affect the during his famous South China tour, and future trajectory of the world’s economies. accession into the World Trade Organiza- tion (WTO) as milestones, China expanded g lobal Megatrends and deepened its economic integration with the global economy. This policy reaped large The last three decades saw a supportive dividends for China, bringing investments, global environment that undoubtedly assisted advanced technologies, and managerial and accommodated China’s rapid growth. expertise; opening the international market Key elements included relatively open trade, for China’s goods and services; and giving a rising flows of foreign direct investment, boost to China’s internal economic reforms. steady growth in the world’s major markets, The proximity of Hong Kong SAR, China, sharply declining transport costs, increased and Taiwan, China, helped, as did a large intraindustry trade, and the introduction Chinese diaspora dispersed across the globe. and spread of information and communica- tions technology. While extrapolating lin- early from the past may be dangerous, some of these trends are indeed likely to persist. Trends and Characteristics at There is widespread consensus, for example, Home and Abroad in the that in addition to China, other developing Next Two Decades countries, especially middle-income emerg- China’s reforms, still ongoing, have facili- ing markets, will continue to outperform the tated regional concentration of activities advanced economies as they have for the past and captured agglomeration economies in decade. One reason is their continued poten- coastal provinces, encouraged mobility of tial for technological catch-up. The other is factors and goods across provinces and with continued slow growth in advanced econo- the rest of the world, and established a high mies owing to deleveraging and the impact savings- and investment-led growth process of high sovereign debt burdens. By 2030, disciplined by the competitive pressures of developing countries are expected to contrib- globalization. Most important, China has ute two-thirds of global growth (40 percent, avoided economic setbacks: not only did excluding China) and half of global output economic growth average nearly 10 percent (30 percent, excluding China), and will be the over more than three decades, it fell measur- main destinations of world trade. The larger ably below 8 percent only twice. During the emerging markets—China more so than oth- recent global financial crisis, China’s contin - ers—will act as additional growth poles in a ued rapid growth was a significant stabilizing multipolar world economy. force that partly counterbalanced the impact Perhaps the most important global mega- on global economic activity of the down- trend is the rise of China itself. No other coun- turn and subsequent tepid recovery in the try is poised to have as much impact on the advanced economies. global economy over the next two decades. Will China be able to sustain this per- Even if China’s growth rate slows as pro- formance over the next two decades? Much jected, it would still replace the United States depends on how the global environment as the world’s largest economy by 2030, its evolves and on the structural forces that share in world trade could be twice as high, are already at work within China. But this it is likely to remain the world’s biggest emit- much is certain: trends at home and abroad ter of carbon dioxide, and, notwithstanding over vie w 7 shrinkage in its trade surplus, it is expected will be trade in services, now the fastest- to remain the world’s largest creditor. Some growing component of global trade. Thanks have argued that by 2030, China’s inu fl ence to new informational technologies, services in the global economy could approach that previously considered nontradable (such as of the United Kingdom in 1870 or the United health and education) will be routinely pro- States in 1945 (Subramanian 2011). vided across national borders just as manu- Continued rapid growth in emerging factures are now. In addition, the world is markets will give rise to an unprecedented continuing to see further global relocation expansion of the global middle class (by of industries (and, increasingly, tasks within one estimate, from less than 1.8 billion peo- industries) in the incessant search for global ple in 2009 to about 5 billion in 2030, of competitiveness. whom nearly two-thirds will be in Asia). The number of free trade arrangements in That expansion will trigger an explosion in the world has multiplied manifold over the demand for housing and consumer durables, past two decades; over the next two, trade including automobiles. The pressure on integration will intensify and production net- global supplies of energy, natural resources, works will expand further. Intra–East Asian food, water, and the environment will ratchet trade could rival that of intra-European trade up rapidly. Climate change effects could (as a share of GDP). Emerging markets will exacerbate food and water shortages in some develop an increasing stake in an open global areas. The price of raw materials will remain trading system. The resolution of climate elevated and volatile. Higher prices for scarce change, international financial stability, inter - natural resources highlight the need to intro- national migration, health pandemics, water duce “green growth” strategies that could management, and other global challenges potentially become a new source of growth. will require new approaches to transnational Notwithstanding the potential for rapid and global governance arrangements. growth in emerging markets, there are also The U.S. dollar will likely remain the reasons to believe that growth in developing world’s major international reserve currency, countries, including China, will slow. First, as especially given weaknesses in the Euro Area populations age, the growth rate of the labor and Japan. But expansionary monetary poli- force will slow, and in some countries (such cies in the advanced countries, including the as China and the Russian Federation) will United States, will cause instability in the even decline, leading to higher dependency international monetary system, and uncer- ratios and lower savings and investment. Sec- tainty in key exchange rates will add to costs ond, although emerging market economies of international monetary and trade transac- will retain a comparative advantage in manu- tions. China’s growing weight in world trade, facturing, rising unit labor costs will further the size of its economy, and its role as the increase their relative share of services; over- world’s largest creditor will make the interna- all growth would thus slow because produc- tionalization of China’s renminbi inevitable, tivity growth in services is usually lower than but its acceptance as a major global reserve in manufacturing. currency will depend on the pace and success While protectionism may occasionally of financial sector reforms and the opening rear its head, especially in advanced coun- of its external capital account (see chapter 8). tries where the impact of the recent financial Technological breakthroughs, unpredict- crisis has been particularly severe, the forces able as they may be, are more likely in some of globalization will remain irresistible, and areas, such as clean water, energy storage, further cross-border movements of goods, and biotechnologies, than in others. A break- services, finance, people, and knowledge will through in clean coal technologies would give endure and deepen. Production chains across China an obvious advantage, given its huge borders will continue to flourish, and intrain - coal reserves. Renewable energy technologies dustry and intrafirm trade will intensify. could also become more economically viable. As global trade continues to grow at a The recent pattern has been for such techno- more rapid rate than GDP, the new frontier logical breakthroughs to occur in advanced 8 c h i n a 2030 countries, with their application in commer- These factors, together with “rebalanc- cial and mass production usually transferred ing” policies to emphasize domestic growth to developing countries. This pattern is likely sources, will contribute to a higher share of to continue; adoption, adaptation, and mas- services and consumption in the economy tery of existing technologies will remain an and a lower share of exports, savings, and important growth driver in developing coun- investment. The challenge will be to support tries. At the same time, however, as emerg- these growth and structural transitions while ing markets develop their own technological avoiding sudden slowdowns and possible capability, new and disruptive technologies crises. will appear in the developing world and raise China’s external accounts are expected to the chance of “leapfrogging” over advanced show a decline in the trade surplus—export countries in a few areas. growth will slow as China’s global market share rises and markets in advanced coun- tries grow more slowly, while import growth Major Trends within China will be driven by continued expansion in Just as growth is expected to slow in some domestic demand. At the same time, how- emerging markets over the coming two ever, the external capital account will show a decades, many signs point to a growth slow- rising deficit as Chinese savings flow abroad down in China as well (Liu et al. 2011). in search of better returns and to counter Indeed, we expect GDP growth to decline protectionist pressures abroad. This trend gradually from an average near 8.5 percent will serve not only to keep in check further in 2011–15 to around 5 percent in 2026–30 accumulation of external reserves but also (see table O.1). One reason for the slowdown to facilitate the transformation of Chinese is that much of the growth contribution from enterprises into global players. shifting resources from agriculture to indus- China’s current pattern of development try has already occurred. And going for- has also placed considerable stress on the ward, the continued accumulation of capital, environment—land, air, and water—and although sizable, will inevitably contribute has imposed increased pressure on the avail- less to growth as the capital-labor ratio rises ability of natural resources. The challenge (even though capital stock per worker, now an going forward will be to convert these pres- estimated 8.7 percent of the U.S. level, under- sures into new sources of growth by adopt- scores the need for further capital accumula- ing a green growth model that taps into new tion). Moreover, China is poised to go through global markets in green technologies while at wrenching demographic change: the old age the same time solving many of China’s own dependency ratio will double in the next two pressing environmental concerns. If success- decades, reaching the current level in Norway ful, the energy and commodity intensity of and the Netherlands by 2030 (between 22 production is expected to decline signifi- and 23 percent); and the size of China’s labor cantly by 2030 for three reasons: a smaller force is projected to start shrinking as soon share of industry in GDP; a smaller share as 2015. Yet workers will become more pro- of resource- and pollution-intensive firms ductive as physical and human capital stock in the industrial sector; and better pricing per worker continues to rise. Finally, total fac- of energy, commodities, and environmental tor productivity (TFP) growth—a measure services (see chapter 5). of improvements in economic efficiency and Income inequality in China, which technological progress—has also declined, climbed continuously over the past two in part because the economy has exhausted decades, is showing some tentative signs gains from first-generation policy reforms and of beginning to flatten and possibly even the absorption of imported technologies. As a decline. In the coming decades, three under- result, the distance to the technological fron- lying structural factors could serve to con- tier has shrunk, and second-generation policy firm this inflexion point. First, acceleration reforms are likely to have a smaller impact on of growth in the middle and western regions growth. will continue, so the income gap between over vie w 9 TABLE O.1 China: Projected growth pattern assuming steady reforms and no major shock Indicator 1995–2010 2011–15 2016–20 2021–25 2026–30 GDP growth (percent per year) 9.9 8.6 7.0 5.9 5.0 Labor growth 0.9 0.3 –0.2 –0.2 –0.4 Labor productivity growth 8.9 8.3 7.1 6.2 5.5 Structure of economy (end of period, %) Investment/GDP ratio 49 42 38 36 34 Consumption/GDP ratio 47 56 60 63 66 Industry/GDP ratio 46.7 43.8 41.0 38.0 34.6 Services/GDP ratio 43.1 47.6 51.6 56.1 61.1 Share of employment in agriculture 36.7 30.0 23.7 18.2 12.5 Share of employment in services 34.6 42.0 47.6 52.9 59.0 Sources: NBSC and DRC. the coast and the interior will narrow. Sec- At the same time, China’s existing com- ond, migrant wages will continue to rise parative advantage in low unit labor costs rapidly, reducing the income gap with urban will shrink gradually. Rapidly rising real residents. The role of policy will be to sup- wages for unskilled workers in coastal prov- port these structural forces by increasing inces are encouraging firms to relocate to the equality of opportunity (see chapter 6). neighboring interior provinces where labor Third, even though the urbanization rate is and land are more plentiful and relatively expected to continue its rise, rural-urban cheap. Thanks to continuous improvements migration will gradually slow over the period in connective infrastructure between the as the structural shift from agriculture to interior and major cities and ports, the incre- manufacturing eases, and the rural-urban mental transport costs from interior locations wage gap narrows (the urban-rural income will be outweighed by the benefits of lower ratio is expected to fall from 3.2 : 1 in 2010 input costs. to 2.4 : 1 in 2030). The rise in wages associated with At the same time, rising educational stan- increased productivity will continue to spur dards and brisk growth in tertiary educa- rapid expansion in the ranks of the middle tion is rapidly increasing the numbers of class, which, in turn, will increase con- skilled workers and helping China move up sumption of consumer durables and raise the value chain, and this process is likely to the share of consumption in GDP. And, as accelerate in coming decades. The grow- international experience shows, a growing ing skill base will facilitate a further shift middle class will also act as a catalyst for in production from labor-intensive to skill- improved governance, better delivery of intensive activities and an increase in the public services, and the empowerment of pace of innovation. Indeed, just as in the civil society. 1980s and 1990s when hundreds of millions And finally, China’s urbanization—a of unskilled Chinese workers joined the driver of much of China’s increased global global labor force as part of China’s “open- competitiveness—is poised to grow rapidly. ing up” strategy, so too will tens of millions Over the coming two decades, the increase of tertiary-educated Chinese workers join in the urban population will be the equiva- the global workforce to significantly expand lent of more than one Tokyo or Buenos Aires the global supply of skill-intensive products. each year as the share of urban residents in Indeed, the number of college graduates the total population climbs from about one- could swell by 200 million over the next two half to near two-thirds in 2030. This will decades—more than the entire labor force of act as another powerful driver of growth, the United States. although much will depend on how well 10 c h i n a 2030 urban development policies are designed and competitive force in global markets in their implemented. own right. This transition would present an opportunity to improve quality, safety, and environmental standards that would provide a competitive edge abroad and improve con- Opportunities and r isks sumer experience at home. g oing Forward Growing recognition within China These global and internal trends offer China that the current pattern of production and many opportunities that could support rapid growth is unsustainable is giving rise to new growth in the next two decades—and give approaches toward realigning government rise to many risks that could threaten that priorities. A fresh emphasis on the qual- growth. Any development strategy going for- ity—not just the pace—of growth provides a ward would need to build on the opportuni- promising opportunity to encourage compe- ties and manage the risks. tition between local governments on the basis First consider the opportunities. Con- of a broad development index incorporating tinued rapid economic development and a mix of social and environmental measures decreases in inequality will swell the ranks that can be added to existing indicators of of the middle class and accelerate domestic economic growth. Realignment of priorities demand for income-elastic products, such would also be consistent with the expected as consumer durables, leisure activities, and increase in demand from the rising number of housing, as well as better health and educa- middle-class Chinese seeking improvements tion services. This, together with the rapid in their quality of life. growth of other emerging markets where At the same time, global and domestic similar transformations are taking place trends are also likely to give rise to many (albeit at a slower pace) will afford new risks that could slow economic growth and opportunities to Chinese enterprises, enable disrupt China’s progress to become a high- economies of scale in production and market- income, harmonious, and creative society. ing, and provide fresh incentives to increase Managing the transition from a middle- international competitiveness through inno- income to a high-income society will itself vation and technological development. prove challenging, and a global environment Increased specialization, intraindustry that will likely remain uncertain and vola- trade, and the two-way flow of investment tile for the foreseeable future makes the task will allow China to continue to exploit doubly daunting. The next five years will opportunities to narrow the gap between its be particularly risky as the global economy capabilities and the technological frontier enters a new and dangerous phase and works through adoption, adaptation, and mastery its way through the aftereffects of the global of existing technologies. The country’s high financial crisis and adjusts to the “new savings rates will allow it to replenish its capi- normal.” tal stock relatively quickly, and that will con- There is broad consensus that China’s tinue to facilitate rapid technological catch- growth is likely to slow; annual average up (g fi ure O.2). And with improvements in its growth over the next 20 years is expected to own research and development capabilities, be one-third less than annual average growth China itself could become a global source for the past 30 years (6.6 percent versus 9.9 of product and process innovation as well as percent). While this will be enough to propel occasional technological breakthroughs. China into high-income status by 2030, there China’s growing technological prowess is no saying whether this slowdown will be will lead to rapid change in its industrial smooth or not. Any sudden slowdown could structure, which will create new areas of unmask inefficiencies and contingent liabili - dynamic comparative advantage. Just as its ties in banks, enterprises, and different levels construction industry has become a global of government—heretofore hidden under the leader in construction projects internation- veil of rapid growth—and could precipitate ally, so too will other industries become a a fiscal and financial crisis. The implications over vie w 11 FIg Ur E O.2 Savings in China compared to other economies a. High savings will continue to be key to b. . . . which was high even by China’s rapid growth . . . East Asia’s high standards 0 10,000 20,000 30,000 40,000 50,000 –10 –5 0+5 +10 +15 +20 +25 +30 Years since reforms GDP per capita, constant prices China (year 0 = 1978) China (1974–2009) Thailand (1965–2009) Former Soviet Union (year 0 = 1990) Korea, Rep. (1965–2009) Japan (1974–2009) Eastern and Central Europe (developing) (year 0 = 1990) Malaysia (1965–2009) Hong Kong SAR, China (1965–2009) Singapore (1965–2009) Source: World Bank 2011b. for social stability would be hard to predict even stagnation. Over the past half century, in such a scenario. many countries have entered middle-income How government responds to a rapid status, but very few have made the additional slowdown will depend on its causes. One leap to become high-income economies. cause could be a macroeconomic shock, say, Rather, several faced sudden, sharp decel- a sudden decline in real estate prices and a erations in growth and have been unsuccess- sharp contraction in construction and invest- ful in addressing the root structural cause ment, or a rapid growth slowdown in the of the slowdown. China does not have to advanced economies leading to sharply lower endure this fate. Successful implementa- global trade and growth. Such risks could be tion of the reform policies, contained in this significant in the short term, and there is a report, aimed at finding new growth driv- likelihood that China could face just such ers—increased efficiency in input use, higher challenges over the course of the next two human capital investments, increased innova- decades. Fortunately, unlike many other tion, and a shift to high-value services—will countries, China’s fiscal and debt position help China avoid the middle-income trap and allows it the space to respond with counter- maintain an expected average growth rate of cyclical measures. But these short-term policy between 6 and 7 percent a year in the com- responses should also be supportive of long- ing two decades, compared with an average term structural reforms (such as those recom- of nearly 10 percent a year in the past three mended in this report). decades. Another cause of a growth slowdown— The risk of sharply lower growth rates is arguably one of greater concern—could be exacerbated by China’s relatively high income structural in nature, the so-called middle- and asset inequality, low consumption, and income trap (box O.1). If, instead of respond- unequal access to quality public services (fig - ing with policy reforms to address structural ure O.3). Notwithstanding massive internal problems, the government applies macroeco- migration from farms to cities, barriers to nomic measures to stimulate the economy, labor mobility (the household registration, or then inflation and instability could result, hukou, system, the lack of portability of pen- possibly undermining investor confidence sion plans, weak labor market institutions, and ultimately leading to slower growth and and inadequate job market information) have Gross domestic savings (% of GDP) Gross domestic savings (% of GDP) 12 c h i n a 2030 BOX O.1 The middle-income trap sectoral reallocation and technology catch-up are Growing up is hard to do. In the postwar era, many eventually exhausted, while rising wages make labor- countries have developed rapidly into middle-income intensive exports less competitive internationally. status, but far fewer have gone on to high-income sta- If countries cannot increase productivity through tus. Rather, they have become stuck in the so-called innovation (rather than continuing to rely on foreign middle-income trap. The factors and advantages technology), they find themselves trapped. that propelled high growth in these countries during The concept of a middle-income trap has some their rapid development phases—low-cost labor and empirical backing. Latin America and the Middle easy technology adoption—disappeared when they East provide compelling support for the trap hypoth- reached middle- and upper-middle-income levels, esis: in these two regions, most economies reached forcing them to find new sources of growth. middle-income status as early as the 1960s and Low-income countries can compete in interna- 1970s and have remained there ever since (see figure tional markets by producing labor-intensive, low- BO.1.1a). Of 101 middle-income economies in 1960, cost products using technologies developed abroad. only 13 became high income by 2008 (see figure Large productivity gains occur through a reallo- BO.1.1b)—Equatorial Guinea; Greece; Hong Kong cation of labor and capital from low-productivity SAR, China; Ireland; Israel; Japan; Mauritius; Por- agriculture to high-productivity manufacturing. As tugal; Puerto Rico; Republic of Korea; Singapore; countries reach middle-income levels, the underem- Spain; and Taiwan, China. ployed rural labor force dwindles and wages rise, eroding competitiveness. Productivity growth from Figure BO.1.1 Few economies escape the middle-income trap b. a. Hong Kong SAR, China 40,000 Portugal Ireland Middle- Singapore Spain Taiwan, China 35,000 income to Japan Mauritius high-income Israel Equatorial 30,000 Staying rich Guinea 25,000 4 Korea, Rep. Greece 20,000 China Puerto Rico From low- 15,000 income to middle-income Middle-income 10,000 2 “trap” 5,000 0 Low-income ”trap” Becoming poor 123 45 6 Argentina Iran Jordan Malaysia Syrian Arab Republic 1960 per capita income relative to United States (log of %) Brazil Japan Korea, Rep. Peru Thailand Source: Heston, Summers, and Aten 2011. Source: Maddison database. Note: PPP = purchasing power parity. a. The term “middle-income trap” was first defined in Gill, Kharas, and others (2007). “Middle-income economies” are defined in accordance with classifications by income group as given in: http://data.worldbank.org/about/country-classifications. b. In today’s increasingly globalized world, escaping the middle-income trap may be even more difficult (Eeckhout and Jovanovic 2007). trapped tens of millions of farm families in rising share of capital in national income. low-paying, low-productivity work. These Furthermore, the quality gap in public ser- barriers, combined with factor and resource vices available to rural and urban households price policies that favor enterprise prot fi s and has widened, and the “opportunity gap” implicitly tax household incomes, have con- between urban and rural areas has grown. tributed to the declining share of wages and Social tensions have ratcheted up in some GDP per capita, PPP (2005 constant prices) 2008 per capita income relative to United States (log of %) over vie w 13 FIg Ur E O.3 China’s economic challenges a. China is an outlier in consumption . . . b. . . . and investment 140 60 0 0 45 67 8 9101112 45 67 8 9101112 Log real GDP per capita Log real GDP per capita National averages, 2005–09 China, 1980–2009 National averages, 2005–09 China, 1980–2009 Source: World Bank 2011b; NBSC 2010; World Bank calculations. Source: World Bank 2011b; NBSC 2010; World Bank calculations. c. Inequality in China has climbed rapidly . . . d. . . . and environmental costs have been high 45 67 8 9101112 Log real GDP per capita China India Brazil United Korea, Japan Germany National averages, 2000–09 China, 1980–2009 States Rep. Source: Milanovic 2005; World Bank calculations. Source: World Bank 2011b. areas, resulting in a growing number of pub- individuals and nongovernment agencies, lic protests. Unresolved, these tensions could these demands can be transformed into a pose a threat to growth and stability in com- positive force supportive of improved gover- ing decades. nance and public policy formulation. Social risks are also expected to arise from Another risk relates to China’s growth another direction. If the experiences of other pattern, which has been particularly inten- countries is any guide, the rising ranks of sive in energy and natural resource use, con- the middle class and higher education levels tributing to a widening environmental deficit will inevitably increase the demand for bet- and exposing the economy to commodity ter social governance and greater opportuni- price shocks. While the energy intensity in ties for participation in public policy debate most individual industries has been declin- and implementation. Unmet, these demands ing steadily, rapid growth, growing urban- could raise social tensions; but if the gov- ization, and structural change within manu- ernment finds ways to improve consultation facturing have combined to make China the and tap the knowledge and social capital of world’s largest energy user, outstripping the Consumption (% of GDP) Gini coecient Environmental and natural resource Gross capital formation (% of GDP) degradation and depletion, 2008 (% of GNI) 14 c h i n a 2030 United States in 2010 (although, on a per external shocks. Ironically, these reserves capita basis, the United States still consumes face the risk of large capital losses in the face five times more energy than China, and of a weakened dollar. Efforts to export capi- China has raced ahead in generating wind tal in the form of outward FDI, especially to and solar energy). Similarly, rapid growth has secure raw material supplies, has met with led to substantial natural resource depletion suspicion in some receiving countries, and and serious environmental pollution. Uncor- unless appropriate steps are taken to address rected, these trends could, in time, serve as a these problems, such risks and friction could serious constraint on growth. grow. Many of the policies that generated China’s relations with the rest of the world China’s high savings and investment levels are affected by its rapid export growth, also account for its external imbalance, as which has not been matched with equivalent measured by its current and capital account increases in import volumes, and by bilateral surpluses in the balance of payments. The trade surpluses with its key trading partners, combination of these two surpluses has which have fueled protectionist pressures. resulted in record foreign exchange reserves, Indeed, if China’s current export growth per- most of which are invested in low-yield U.S. sists, its projected global market share could securities, while China pays a substantially rise to 20 percent by 2030, almost double higher interest or dividend rate for capital the peak of Japan’s global market share in imports in the form of “hot money” and the mid-1980s when it faced fierce protec- foreign direct investment. China’s current tionist sentiments from its trading partners. account surpluses and reserve accumulation But China’s current trajectory, if continued, are a relatively recent phenomenon, one that would cause unmanageable trade frictions occurred only after the Asian financial crisis. with developed and developing countries well They reflect not only the country’s growing before 2030. The anemic growth of high- role as the center of a rapidly expanding and income countries as they continue to struggle deepening East Asian production network with fiscal consolidation is expected only to but also a policy objective to strengthen the magnify China’s expansion of its global mar- country’s foreign exchange buffer against ket share. over vie w 15 Chapter 2 A New Development Strategy for 2030 China’ successful development strategy over in China that guides the analysis and recom- the past three decades has made it an upper- mendations in this report. middle-income economy today. But the A modern society is industrialized and opportunities and challenges in the next two urbanized and enjoys a quality of life that is decades will be unlike those it encountered in on par with developed countries. This soci- the past and will demand a new development ety would have modern values, a modern strategy. This strategy will need to build on economic and social structure, with access China’s opportunities, meet its challenges, to contemporary, state-of-the-art product manage its risks, and realize the country’s and process technologies, and would engage long-term objectives. But what are those and contribute as an equal with other nations objectives—and what kind of strategy does in the discourse of the modern world on all China need to achieve them? This chapter subjects. begins with a discussion of China’s vision of As a harmonious society, China sees three itself in 2030, identifies the core elements of a interrelated goals. First, its own policies need strategy that would help it realize that vision, to be inclusive and just, aimed at eliminating and examines the characteristics that such a most social and economic boundaries and strategy should have. at building a society in which everyone has a common stake in the country’s economic, social, legal, and political institutions. China The 2030 Vision: To Build a would like to see a society where people show mutual respect, disputes are resolved justly Modern, Harmonious, and and peacefully through accepted norms, laws, Creative Society regulations, and practices—and the institu- In a recent landmark study, the Commission tional structure is quick to adapt to society’s on Growth and Development (2008) identi- changing needs and aspirations. Second, fied five common features in countries that China sees itself living in balance with nature, sustained rapid growth and development for in which its ecological footprint—the use of extended periods: They exploited opportu- resources and creation of waste—are consis- nities in the world economy by maintain- tent with the biological capacity of its (and the ing open trade and investment policies; they world’s) land, water, and air resources given maintained macroeconomic stability; they existing technology. And third, China would enjoyed high savings and investment rates; like to see itself as an equal, constructive, and they allowed markets to allocate resources; accepted partner in the community of nations, and they were led by committed and cred- working peacefully and cooperatively toward ible governments. China belongs to this common goals, and engaging constructively select group and has demonstrated all five on global issues and in global institutions. of these features. The architect of China’s As a creative society, China sees itself reforms was Deng Xiaoping, who played an building its future prosperity on innovation in important role in building consensus for a which everyone’s creative potential is tapped. fundamental shift in the country’s strategy. Its success will lie in its ability to produce After more than 30 years of rapid growth, more value, not more products, enabling it to China has reached another turning point move up the value chain and compete glob- in its development path, one that calls for a ally in the same product space as advanced second strategic, and no less fundamental, countries. Creativity will manifest itself not shift. If managed well, China could become just in product and process technology, but a modern, harmonious, creative, and high- also in cultural and artistic pursuits. If suc- income society by 2030. Each element of cessful, China’s experience could potentially the phrase “modern, harmonious, creative, be a beacon for other middle-income devel- and high income” has specific significance oping countries to follow. 16 c h i n a 2030 As a high-income society, China’s aspira- acceptance of the renminbi as an interna- tion is to enjoy a per capita income on par tional reserve currency. The government’s with advanced economies; have a large mid- economic priority will shift to maintaining dle class that acts as a force for stability, good macroeconomic stability, creating an invest- governance, and economic progress; elimi- ment and regulatory environment conducive nate poverty as it is known today; and pro- for enterprise development, and financing mote social harmony by increasing equality public goods and services. China will be of opportunity and lowering inequality in all competing internationally in the same prod- its economic and social dimensions. uct space as the advanced economies; its uni- If China achieves its goal of becoming a versity graduates will have tripled in num- high-income society by 2030, it will be the ber; and its environment will be significantly world’s largest economy using market prices cleaner. Moreover, with a larger urban popu- (indeed, if GDP is measured by purchasing lation and more efficient transportation and power parity, it could well outstrip the United movement of labor between cities and the States later this decade). China’s incremental countryside, inequality between urban and size in the coming two decades will be equiv- rural areas will continue to decline. alent to 15 of today’s Republic of Korea’s. Even so, its annual per capita income will still The Case for a New Strategy be around $16,000, more than three times today’s level, close to today’s Slovak Republic Realizing China’s vision for 2030 will or Korea, and slightly more than a third of demand a new development strategy. The today’s United States. development strategy it pursued over the Another reality in 2030 that can be fore- past three decades was directed at meet- told with some accuracy will be China’s ing the challenges of a different era. Not demographic transition. Simply put, China only have the challenges changed, so have will grow old before it grows rich. Its low China’s capabilities. No strategy lasts for- fertility rate and consequent low population ever. Successful strategies must be flexible growth rate will mean a rising share of old and adjust in accordance with changing con- people in the economy. The old-age depen- ditions. Middle-income countries unable to dency ratio—defined as the ratio of those make such adjustments have stumbled into aged 65 and over to those between the ages the middle-income trap. China’s top deci- of 15 and 64 —will double over the next sion makers recognize this and have made 20 years (UN 2010; UN 2009). By 2030, transforming the economic development pat- China’s dependency ratio will reach the tern the country’s most important economic level of Norway and the Netherlands today. policy priority. Just as important, China’s working-age Changing the development model is urgent population will decline after 2015. The because, as an economy approaches the tech- urban share of the population is expected to nology frontier and exhausts the potential rise from around 50 percent today to near for acquiring and applying technology from two-thirds by 2030, an average growth of abroad, the role of the government needs to 13 million people each year (NBSC 2011; change fundamentally. Initiating this change UN 2010). early helps smooth the transition from Compared with today, China’s economy in importing new technologies to innovating 2030 will be more complex, market driven, and creating new technologies. knowledge centered, and oriented toward Developing countries tend to benet f fi rom services. Its trade and financial integration the latecomer’s advantage by following a with the global economy will make it more development path adopted by others. This interdependent with other economies and at path makes the role of government relatively the same time more vulnerable to external straightforward—providing roads, railways, shocks. It will have deeper and more stable energy, and other infrastructure to comple- financial markets, which can lay the founda - ment private investment, allowing open tion for an open capital account and broad trade and investment policies that encourage over vie w 17 technological catch-up, and implementing the quality of human capital will require bet- industrial policies when market and coor- ter education, health care, and social secu- dination failures inhibit the development of rity. And it will demand a marked increase internationally competitive industries consis- in equal employment opportunities and tent with the country’s comparative advan- self-employment, as well as greater lateral tage. The development strategies of East mobility of labor from rural to urban areas Asia’s successful economies—Japan; Korea; and across towns, cities, provinces, and occu- Hong Kong SAR, China; Singapore; and pations, and vertical mobility through the Taiwan, China—have all broadly reflected social, economic, and political hierarchies. these features. Another supportive role the govern- But when a developing country reaches ment can play is encouraging greater par- the technology frontier, the correct devel- ticipation in the development process. The opment strategy ceases to be so straightfor- expanding middle class is increasingly vocal ward. Direct government intervention may in its demand to participate in the discus- actually retard growth, not help it. Instead, sion of public policy. This demand points to the policy emphasis needs to shift even more a broader need to empower people to con- toward private sector development, ensuring tribute to the country’s development efforts, that markets are mature enough to allocate be creative, and improve standards of living resources efficiently and that firms are strong through their own efforts. The government and innovative enough to compete interna- should respond proactively to these needs and tionally in technologically advanced sectors. grant rights to individuals, households, enter- The role of the private sector is critical prises, communities, academia, and other because innovation at the technology frontier nongovernmental organizations through is quite different in nature from simply catch- clear rules that encourage broad participa- ing up technologically. The process becomes tion. By doing so, the government can gradu- essentially one of trial and error, with the ally transfer some of its previous functions chances of success highly uncertain. Innova- to society at large, allow nongovernmental tion is not something that can be achieved players to form networks in new and inter- through government planning. Indeed, the esting ways, and create space for innovation more enterprises are involved in the trial-and- and creativity. Moreover, empowering soci- error process of innovation, the greater are ety, especially those who are disadvantaged, the chances for technological breakthroughs, will help unleash new ideas and approaches and the more likely that new discoveries will toward increasing equality of opportunity, be translated into commercially viable prod- ensuring inclusive growth, and achieving a ucts. As enterprises take a leading role, the balance between a caring and a competitive government needs to adopt a more supportive society. and facilitating role. Last, while the government reduces its role One of the key supportive roles the gov- in markets, resource allocation, production, ernment can play is enhancing the quality and distribution, it should step up its role in of human capital. China’s rapid growth has financing public goods and services, protect - been accompanied by a gradual decline in ing the environment, increasing equality of its agricultural surplus labor and a steady opportunity, and ensuring an environment rise in real wages in manufacturing, a trend conducive for private sector development. that appears to have accelerated recently. Playing such an indirect and supportive role Without concomitant increases in labor pro- is complicated but will have a wide impact, ductivity, real wage increases could lead to a with greater leverage through the private steady decline in international competitive- sector and social organizations. While pro- ness. Increasing the quality of human capital viding fewer “tangible” goods and services will not only increase labor productivity and directly, the government will need to provide maintain China’s competitiveness; it will also more intangible public goods and services, allow Chinese manufacturing and services like systems, rules, and policies, that increase to move up the value chain. Improvement in production efficiency, promote competition, 18 c h i n a 2030 facilitate specialization, enhance the effi- this role, the government will need to trans- ciency of resource allocation, and reduce risks form itself into a lean, clean, transparent, and uncertainties. It requires designing and and highly efficient modern government that implementing incentive structures that lead operates under the rule of law. In redefining to desired and sustainable outcomes. its role, the government will need to accel- One key area, for example, is the financ - erate reforms in the state-owned sector and ing of basic public services such as pensions, combine it with further development of the medical care, education, and housing, where private sector. It will also need to advance the government can invest more, drawing reforms in factor markets (capital, land, and on resources it had previously devoted to labor) to help strengthen the foundations infrastructure and manufacturing. Equally of a market economy and promote greater important, the government should be less competition and innovation. At the same concerned with whether the private or the time, society’s role will need to change sig- public sector provides these public goods and nificantly, with the middle class becoming a services—but instead focus on ensuring they major force in promoting harmonious devel- are delivered efficiently and to the requisite opment through greater participation of the quality. Encouraging the private provision people in the development process. of public goods and services and forming public-private partnerships where appropri- Key Characteristics of the ate will not only inject new skills and ideas New Strategy into public service delivery but also empower the private sector and encourage greater Before describing a proposed development participation in the development process. strategy, it is worth highlighting five charac - Another example is the environment, an area teristics that should lie at its core. requiring strong action by the government. The first is improvement in the qual- Not only will green development improve the ity of growth while continuing to increase quality of life in China, it will contribute to incomes. Not only does China aspire to global efforts at mitigating climate change. become a high-income society that enjoys As the second-largest economy with the larg- sustained growth, it would like to see growth est population in the world, China is bound measured in qualitative as well as quantita- to shoulder increasing global responsibili- tive terms. Rising incomes need to be accom- ties and play an important role in delivering panied by increased leisure, a better physical global public goods. To do this, it will need environment, expanding arts and cultural to align its national interests to global con- activities, and a greater sense of economic cerns and build its capacity to participate and social security. Correspondingly, the actively in global affairs and to design global incentive structure that drives central and rules instead of merely accepting them. local government performance will also need In sum, it is imperative that China adjusts to reflect this changed emphasis. China needs its development strategy as it embarks on its to develop a new metric to measure prog- next phase of economic growth. At its core, ress over the coming decades that balances this adjustment requires changing the role of growth and income objectives with broader government and its relations with the mar- welfare and sustainability goals. ket, the private sector, and society at large. The second is to achieve balanced and While the government needs to withdraw sustainable growth, consistent with mar- from direct involvement in production, dis- ket forces. There is broad recognition in tribution, and resource allocation, it will China—as reflected in the 11th and 12th need to focus greater attention on design- Five Year Plans—that the country’s pattern ing and implementing the policy and regu- of investment and growth has become largely latory framework that empowers others to unsustainable. Spurred by high savings, participate in economic decision making so cheap finance, and export-oriented policies, that the desired outcome of rapid, inclusive, China’s impressive growth rate has been and sustainable growth is achieved. To play capital intensive, industry led, and export over vie w 19 dependent for several years. Compared with services. Most services have become trad- rapidly growing manufacturing, the develop- able internationally, and China can benefit ment of services has lagged (though the sta- from agglomeration economies and interna- tistics may exaggerate the degree of lag). The tional specialization in services just as it has shares of wages and consumption in national in manufacturing. For example, if China suc- income have fallen steadily; the shares of ceeds in becoming a leading innovator in the capital and investment have climbed. Rural- field of green development, then its expertise urban inequality has expanded since the and knowledge on this subject will likely be 1990s. China is home to more than a million sought worldwide. Similarly, if China’s finan - millionaires, while more than 170 million cial sector is strengthened to the point that live on less than $2 a day. the capital account can be liberalized and the Returning to balanced and sustainable renminbi become a key international reserve growth will require a rise in the shares spent currency, then China could become a key on services and consumption as per capita exporter of financial services. income increases. This will be achieved, in The fourth is unleashing China’s full part, by correcting factor price distortions human potential. Equality of opportu- that implicitly tax labor and subsidize capi- nity will not only help unleash China’s full tal. Correcting such distortions and allowing human potential, it will also support inclu- market-driven structural change will not only sive growth and improve income distribution. help achieve greater balance between manu- Increasing equality of opportunity should not facturing and services but also in the distri- be restricted only to public services, such as bution of income between capital and labor health or education; it should also include and between rural and urban households. economic opportunities such as access to The third is to strengthen innovation and jobs, finance, or official permits to start a creativity. While development of services will business. One way to increase equality of need to be a priority in the coming decades, opportunity in the enterprise and financial manufacturing growth will continue to be an sectors will be to allow more competition in important growth driver. After all, notwith- factor markets (labor, land, and capital) as standing recent rapid increases in real wages, well as product markets. More competition, China’s low-cost labor, especially in inte- of course, can come from abroad through rior, less-developed provinces, will remain boosting exports and lowering import barri- an advantage for many years to come. But ers, but it can also be encouraged by easing rather than focus purely on growth, poli- the entry and exit of firms in the domestic cies will need to encourage manufacturers market, giving small and medium enterprises to move up the value chain and advance rap- (SMEs) greater access to finance and market idly to the global technology frontier (and, opportunities, opening up public procure- in some areas, push that technology frontier ment by making procedures transparent, and forward). Services like research and devel- creating new opportunities for the private opment (R&D), finance, logistics, training, provision of public services by separating information services, and after-sale services financing from delivery. Smarter and more will help. Achieving this will require further effective regulation can do more than just integration with the global economy and help level the playing field between big enter - increased specialization, as well as participa- prises and small ones. It can also help protect tion in global R&D networks and marketing consumers, workers, and the environment; arrangements. safeguard private and intellectual property But it would be a mistake to believe that rights; ensure greater financial sector stabil - innovation will be restricted to manufac- ity; and provide a solid foundation for corpo- turing. If China is successful in nurturing a rate governance to guide enterprises. culture of open innovation, then the services Equality of opportunity also means higher sector could also be an important beneficiary, public participation in public policy formu- and there is no reason why China should not lation, implementation, and oversight. As become an important exporter of high-end economies grow in size and complexity, the 20 c h i n a 2030 task of economic management becomes more values and moral standards should be reex- complicated, and governments usually find amined and reinforced. From a social per- that they alone do not, indeed should not, spective, not only will this contribute to have all the answers. Governments, there- improving the quality of life, it will also fore, tend to tap the knowledge and social provide a greater sense of community and capital of individuals and nongovernment enhance social cohesion. From an economic agencies, including universities, communities, perspective, it will reduce transaction costs and think tanks. One of the hallmarks of and improve the quality of economic gov- advanced economies is their public discussion ernance. Promoting social values and high of public policies. Indeed, such discussions moral standards is not only the job of gov- are already beginning in China, but there is ernment; it is also the duty of social orga- a long way to go. Public consultations and nizations and, indeed, every citizen. Moral policy debate ensure that all points of view awareness, not legal compulsion, should be are considered before government reforms the hallmark of a high-income, harmonious are introduced. These discussions not only society. shrink the distance between the government and the citizens and communities it serves, Six Key Directions of the but they also encourages stakeholders’ own- New Strategy ership of new policies, help render reform proposals intelligible to citizens and firms, Over the next two decades, China will face and enhance the chances of success. many challenges in its quest to become a The fifth (and last) values the role of the modern, harmonious, and creative high- market, rule of law, social values, and high income society. These include transitioning moral standards. As the government tran- government from being an active partici- sitions away from direct intervention in pant in the economy to developing the legal, enterprise and market activities and toward regulatory, and institutional framework sup- creating a policy and regulatory environ- portive of a competitive market environment; ment supportive of free and fair competition, implementing a “smart” urbanization strat- it must also safeguard the rule of law. In a egy; encouraging innovation and industrial similar vein, as the Chinese economy grows upgrading; reducing income inequality and in complexity, not only must rules and regu- ensuring equal opportunity for all; modify- lations evolve to reflect changing reality and ing its approach toward handling economic emerging priorities, but they should be fairly relations with other countries; and playing and effectively enforced. If the enforcement a more constructive role in a rapidly chang- of standards varies from sector to sector, ing system of global governance. In reality, region to region, entity to entity, and some- the list of challenges is much longer. While times even person to person, then it will not some consensus has emerged with respect to only discourage innovation and lead to ineffi - a few of those issues, controversies remain cient economic outcomes, it will also contrib- and an intense debate is ongoing over key ute to feelings of injustice. Where contract aspects. This report evaluates the major chal- disputes arise, whether between private par- lenges China needs to tackle in the next two ties or between private entities and the State, decades and identifies six new strategic direc - the disputants should have access not only to tions that will form the core components of legal recourse but also to a transparent and the new strategy. effective judicial system that imparts justice The first new strategic direction is the without fear or favor. appropriate role of the government, the state, Similarly, social values and high moral and the private sector. The recent global standards will be important. There is wide- financial crisis in the advanced economies spread concern in China over many recent and, in stark contrast, China’s continued rapid instances of “moral failures” that were growth despite the global slowdown, have reported widely in the media. As China led some in China to conclude that China’s becomes a high-income society, its social state dominance in key industrial and service over vie w 21 sectors should continue (especially in the finan - strategy may yield short-term gains but will cial sector). Others, however, counter that be ultimately self-defeating, while an open China’s vision of itself in 2030 as an innova- innovation strategy promises more sustained tive, high-income society will require markets long-term rewards. and the private sector to play a bigger role in The third new strategic direction is that resource allocation decisions. They consider China should “grow green.” Instead of the dominance of the state in the economy as considering environmental protection and potentially inhibiting China’s efforts to move climate change mitigation as burdens that up the value chain. This report makes two hurt competitiveness and slow growth, this points: first, that government should encour - report stresses that green development could age increased competition in the economy, potentially become a significant new growth including by increasing the ease of entry and opportunity. Much will depend on how exit of firms as soon as possible; and sec- effectively government policies make firms ond, that public resources should be used to internalize negative externalities and moti- finance a wider range of public goods and vate firms to innovate and seek technological services to support an increasingly complex breakthroughs. China does not want to rep- and sophisticated economy. Reforms of state licate the experience of advanced countries enterprises and banks would help align their that became rich first and cleaned up later. corporate governance arrangements with the Instead, China intends to grow green by fol- requirements of a modern market economy lowing a pattern of economic growth that and permit competition with the private sec- boosts environmental protection and techno- tor on a level playing field. This would create logical progress, a strategy that could become the appropriate incentives and conditions for an example to other developing countries and increased vigor and creativity in the economy perhaps even advanced economies. in support of China’s successful transforma- The fourth new strategic direction is to tion into a high-income society. promote equality of opportunity and social The second new strategic direction is protection for all. China’s high inequality in encouraging systemwide innovation and incomes and assets can, in part, be attrib- adopting an “open” innovation system with uted to unequal access to quality public ser- links to global R&D networks. Although vices, particularly those that help accumulate China’s R&D investment as a share of GDP is human capital and increase public partici- high by international standards for a country pation in the development process. Policies at its per capita income level, much needs to should promote the equality of opportunity be done to ensure that this investment yields to help all members of society, especially the commercially viable innovations that will disadvantaged, who have the same rights as help Chinese firms move up the value chain everyone else to access social and economic and compete effectively in the same product services as well as employment opportuni- space as advanced economies. Ensuring free ties. Promoting equality of opportunity will and fair competition for all enterprises would largely entail increasing the quality of public be the single most important policy to encour- services available to rural residents, migrants age innovation, which is likely to be driven by in urban areas, and those in poor, interior large private firms. Without competition, the provinces. While increasing the efficiency effects of other policies aimed at encourag- of public service delivery can save public ing innovation will unlikely have much effect. resources that can then be used to increase At the same time, technology development the quality of public services, there will still worldwide has become a collaborative exer- be a need to increase the allocation of pub- cise in which countries benefit from special - lic resources toward this objective. Given ization, just as they do in manufacturing or China’s sound fiscal situation, the temptation services. China would therefore benet fi from will be to design a public service and wel- participation in global R&D networks just fare system that is comparable to advanced as it benefited from participation in global economies. But China needs to ensure that production networks. A “closed” technology spending on public services is increased 22 c h i n a 2030 prudently and in line with available fiscal The sixth new strategic direction is to space. China does not intend to fall victim develop mutually beneficial relations for to the “high-income trap” whereby publicly the rest of the world. Notwithstanding tepid financed social entitlements become fiscally growth in advanced countries likely for the unsustainable. foreseeable future, China must continue The fifth new strategic direction is to its integration with global markets even as build a sustainable fiscal system that will it reorients the economy toward domestic meet expected public finance challenges sources of growth. While further integra- over the next two decades. Over the coming tion may bring its own risks, the benefits of two decades, China’s fiscal system will face openness will be central to increasing effi- three major challenges. The first will be to ciency, stimulating innovation, and promot- make the fiscal system resilient to macroeco - ing international competitiveness. Opening nomic shocks and a protracted growth slow- up served China well in the past, especially down; the second will be to accommodate after its entry to the World Trade Organi- new public expenditure demands linked to zation (WTO), and further integration will the adoption of the new development strat- serve it well in the future, particularly for egy; and the third will be to make the fiscal the development of the services sector. China system transparent and responsive to policy also needs to engage with global governance adjustments. Given the likelihood of a pro- institutions proactively as an international tracted growth slowdown at some point in stakeholder to help shape the global policy the next two decades, it is important that environment in a manner that is mutually China’s fiscal system is able to adjust pub - beneficial for China and the world. lic expenditures in line with an expected The six new strategic directions provide rapid deceleration in revenue growth. It is an internally coherent policy framework and also important for China to maintain ade- form the key pillars of the proposed develop- quate fiscal space to deal with macroeco- ment strategy for the next two decades. Some nomic shocks, some of which may originate may argue that they may not include some abroad, given the continued uncertainties in important policy areas, but the pillars can be the global economy. applied to explain virtually every significant Moreover, the budget will need to development issue facing China. Box O.2, ac commodate expected increases in public which describes China’s urbanization chal- ex penditures linked to expansions in public lenge, provides a good example. service delivery and the proposed green China’s senior leaders have recognized for de velopment program, while at the same time some time the urgent need to adjust the coun- ensuring that fiscal sustainability is not try’s development strategy and transform impaired. Finally, compared with other coun- the growth pattern. To some extent, China tries, China’s fiscal system remains opaque, is already beginning to do this. A new pol- intergovernmental fiscal relations have not icy direction for the next v fi e years has been been fully reformed and codified, and fiscal elaborated in China’s 12th Five Year Plan risks and large contingent liabilities remain and other policy documents and includes significant. Tackling these challenges will macroeconomic, social, and environmental require a fiscal system that is flexible, trans - targets as well as pilot applications of the parent, prudently managed, and responsive to “happiness” index to evaluate local govern- emerging priorities. The efforts to strengthen ment performance. The plan is the first step and reform the fiscal system will also need to in a longer-term shift in China’s development be aligned with the broader objective of reori- strategy and is consistent with the reform enting the role of government vis-à-vis the program described in this report. private sector and with the longer-term needs Chapters 3–8 discuss the six new strategic of a changing economy. directions in greater detail. over vie w 23 BOX O.2 Smart urbanization adequate levels of public services—especially health, Meeting China’s urban challenge presents an interest- education, transport, water, and energy—in ways ing example of how the policy priorities highlighted in this report—economic policies, innovation, green and at prices that encourage efficient use. Finally, cit - development, social policies, fiscal strengthening, ies that invest in effective risk reduction and disaster response capabilities often find these will be among and global integration—need to interact with one the best public investments they make. another to bring about desired change. Over the long term, the health and vitality of Perhaps the most important recommendation for China’s rapidly growing urban areas will not only be smart urbanization is the critical need to improve the fiscal strength of municipalities (along with other central to continued rapid growth but will also hold local governments) and reduce the large disparities the key to greater equality and less resource-intensive growth. In 1978, less than a fifth of China’s popula - in resource availability between cities. Strengthen- tion resided in cities; by 2009, urban residents made ing the resource base of cities will require improved arrangements for tax sharing and transfer payments up close to half the population; and by 2030, the with the central government as well as new tax share is expected to swell to near two-thirds. That means about 13 million more urbanites each year, instruments, such as land and property taxes, that or the equivalent of the total population of Tokyo or permit an elastic tax base. There are two reasons why this is a priority. The first obvious one is that Buenos Aires. Rapid as this may seem, China’s urban- city governments need adequate resources to meet ization level by 2030 will be broadly in line with other countries with a similar per capita income. the needs of recurrent expenditure and investment, Interestingly, China’s 20 fastest-growing cities are taking into account the future growth of population and economic activities. Second, in the absence of located inland with per capita incomes that are such tax instruments, local governments will con- rapidly catching up with coastal cities. These cities can access the main metropolitan centers thanks tinue to use land sales as a key source of revenues. to low-cost transport links and communications Besides increasing the pressure on arable land, this practice also tends to continuously expand city facilities, while at the same time derive advantages size, contributes to urban sprawl, reduces popula- from the ease of face-to-face communication and social capital accumulation facilitated by spatial tion densities, and raises costs of transport and compactness. infrastructure. The second complementary policy would be Most urban growth in the future will result from to restrain the geographic expansion of cities and the expansion of existing cities through migration from rural areas. As recent research shows, cities are increase the population density of cities. Several strong engines of growth. They permit economies of Chinese cities are already quite densely populated by international standards, but for those that aren’t, scale and scope in production and distribution and further increases in density will lower the cost of facilitate technology spillovers. Thanks to higher population densities in cities, private and public public and infrastructural services, improve energy investments are more cost-effective and yield higher and transport efficiency, and reduce the loss of arable land. There remain large tracts in the core of major returns. And by bringing a critical mass of talent cities that are underused owing to ownership still together in compact space, cities often become cru- cibles for innovation. vested in state enterprises or local interest groups But for urbanization to be supportive of rapid that prevent efficient urban development. Increased population density can be consistent with growth in and efficient growth, it should be “smart” as well value added only if urban land and property markets as rapid. Smart urbanization involves delivering (box continues next page) 24 c h i n a 2030 BOX O.2 (continued) function smoothly. Of course, increased density has suggestions on how they can be improved. A third its limits, but expanding city areas should be under- way is to support the participation of social and vol- taken carefully and only when other alternatives to untary organizations in delivering services (including combat congestion are exhausted. Adequate density health and education). Experimentation is already needs to be accompanied by increased intra- and ongoing along these lines in many cities but needs intercity connectivity. Intracity connectivity, critical to be encouraged and expanded, and substantial to reducing the carbon footprint of cities and boost- changes need to be made in government practice and ing city efficiency, requires providing viable options attitude. The government can then focus on being a to private automobiles. Increasing connectivity regulator and coordinator. Identifying the services between cities reduces economic distances, encour- that can be provided in this way should be the out- ages growth of satellite cities, advances specializa- come of discussions and decisions at the local level, tion, supports greater scale economies, and increases with guidance from the central government. international competitiveness. The fifth recommendation is to advance the gov - The third is the importance of strengthening ernment’s efforts to make cities knowledge centers urban land use planning. Planning is important to and incubators for innovation. The government has ensure an appropriate balance between green areas, already identified 20 pilot cities for those efforts. But residential areas, factories, businesses, shopping what more can it do? One approach is to ensure that areas, and recreational facilities such as parks and as many cities as possible provide the essentials for playing fields. Urban areas that mix residential, rec - becoming knowledge centers—sound infrastructure, reational, shopping, and business facilities tend to modern transport and telecommunication facilities, develop more vibrant communities, have a smaller local universities and research centers, and a critical ecological footprint, enjoy lower crime rates, and mass of skilled labor. Those that do not make the generally improve the quality of life. At the same leap to becoming knowledge centers will still be bet- time, planning has its limits and planners cannot ter positioned to attract manufacturing or service anticipate the future perfectly. City designs therefore industries. Those fortunate enough to attract world- need to evolve continuously to respond to the needs class firms or world-leading technology R&D centers of citizens as lifestyles change. This requires constant beyond a particular threshold could receive local and public and private investments, reinforcing the need central government support in the form of additional for sound fiscal systems. It also demands a new role ancillary services, including research institutes, uni- for government and emphasizes the importance of versities, and related and sponsored links to other good governance. research organizations. Some urban centers have The fourth is effective and good urban gover- already made this leap and are becoming recognized nance, which goes beyond efficiency, integrity, and knowledge and innovation centers—opto-electronics transparency, although these are very important. It for Wuhan, aviation for Chengdu, financial and engi - includes responsiveness to citizen needs, and the abil- neering services for Shanghai, logistics and business ity to use the energy and capabilities of private enter- services for Shenzhen, information technology (IT) prises and civil society organizations. One way is to and software for Beijing—and should be supported invite citizen participation in land use planning and in becoming centers of excellence. In others, such as zoning, which not only harnesses public creativity Chongqing, efforts are ongoing. In identifying what but also reminds officials to look beyond the interests to support, governments need to remind themselves of individual sectors. Another way is through design- that innovation does not always mean high tech. ing citizen report cards and other similar methods Experience has shown that firms in mature indus - of surveying that regularly assess public satisfaction tries can also be transformed through innovation with the level and quality of public services and seek and become globally competitive. over vie w 25 Chapter 3 Structural r eforms for a Market-Based Economy with Sound Foundations Since 1978, China has made full use of its growth. China’s rapid growth, particularly late-comer advantages in a globalized econ- since 2003, benefited from SOE restruc- omy, experiencing rapid structural change, turing and expansion of the private sector. becoming the world’s largest manufacturer Many small and medium-sized SOEs became and exporter, and rapidly moving toward the privately owned. In line with these develop- technology frontier in many industries. The ments, the new policy direction has been to introduction of the market mechanism and diversify the ownership of state enterprises. openness to trade provided strong incentives Indeed, many large state enterprises have for efficient resource allocation and boosted been “corporatized” and some of the biggest productivity growth. (including those directly monitored by the But the forces supporting China’s con- central government) are now not only listed tinued rapid progress are gradually fading. on stock exchanges but have also improved The productivity benefits from structural their governance structure, managerial pro- change are expected to decline. As China fessionalism, and prot fi ability. approaches the technology frontier, total factor productivity growth from technology Key Issues adoption, adaptation, and dissemination will also almost certainly decline. At the same Relative to the private sector, SOEs consume time, the government’s continued dominance a large proportion of capital, raw materials, in key sectors of the economy, while earlier and intermediate inputs to produce relatively an advantage, is in the future likely to act as small shares of gross output and value added. a constraint on productivity improvements, A large share of state enterprise prot fi s comes innovation, and creativity. from a few state enterprises where profit- At the same time, China’s transition to a ability is often related to limits on competi- market economy is incomplete in many areas. tion and access to cheaper capital, land, and A mix of market and nonmarket measures natural resources. Meanwhile, the financial shapes incentives for producers and consum- performance of some state enterprises has ers, and there remains a lack of clarity in been weak, in part because they have been distinguishing the individual roles of govern- responsible for delivering public services or ment, state enterprises, and the private sector. have been constrained by regulated prices. In It is imperative, therefore, that China resolve fact, more than one in every four state enter- these issues, accelerate structural reforms, prises makes a loss. A recent study also shows and develop a market-based system with that between 1978 and 2007, total factor sound foundations in which public resources productivity growth (a measure of efficiency finance the delivery of key public goods improvements) in the state sector was a third and services—while a vigorous private sec- 15 that of the private sector, which has proved tor plays the more important role of driving to be the more powerful engine of growth growth. This challenge is bigger than it may and innovation. appear because many other constraints to State enterprises have close connections growth, including an anemic global economy with the Chinese government. State enter- and a shrinking and aging labor force, also prises are more likely to enjoy preferential need to be overcome. access to bank finance and other important inputs, privileged access to business oppor- tunities, and even protection against com- Private Sector Development and petition (Li and others 2008). This discour- State Enterprise r eforms ages new private sector entrants and reduces Going forward, a vibrant corporate sector competition and innovation. Some state will be critical for sustaining relatively fast enterprises operate outside their mandated 26 c h i n a 2030 area (many invest in real estate and the seven strategic sectors where the state would shadow banking system), because they can keep “absolute control”—defense, electricity keep their earnings and invest them with generation and distribution, petroleum and limited external control or oversight. A new petrochemicals, telecommunications, coal, issue needing attention is the recent rapid civil aviation, and waterway transport. expansion of some state enterprises owned In these sectors, a handful of state firms by subnational governments; their growth might compete with one another, but they will likely further crowd out private sector are protected by barriers that discourage activity, dampen competition, and conflict new entrants. The Chinese authorities have with efforts to build sound foundations for a also designated “basic” or “pillar” indus- market-based economy. tries—machinery, automobiles, electronics The cost of reforming and restructuring and information technology, construction, state enterprises will not be trivial. Reforms steel, base metals, and chemicals—where in the late 1990s, in which many small state the state is expected to retain a “somewhat enterprises were closed, incurred a cost strong influence” (Owen and Zheng 2007). exceeding RMB 2 trillion—more than 20 Although formal barriers to entry may be percent of GDP at the time—a measure of low in these industries, informal entry bar- how difficult and costly such reforms can be. riers convey the clear policy message—com- Potential costs of reforming and restructur- petition from private firms is not welcome. ing state enterprises may have climbed signif- These barriers, together with less favorable icantly because opaque accounting practices regulatory treatment tend to inhibit private and lack of transparency mean that some sector growth and development, dampen SOEs have accumulated large contingent innovation and creativity, and slow produc- liabilities that will need to be revealed and tivity growth. reduced over time. Finally, the Chinese authorities have imple- Key r eform r ecommendations mented a complex set of industrial policies that are the responsibility of different agen- Reforms in the enterprise sector must begin cies at different levels of government. In some with the recognition that government owner- instances, these policies may have helped by ship is widespread and varied, covering most overcoming coordination failures and pro- sectors and ranging from outright owner- moting infant industries effectively, but in ship to controlling interest to minority share- others, they did not yield the intended results. holder. The challenge, therefore, is twofold: Some government departments are keen to How can public resources best be used; and adopt industrial policies and view such poli- how can China best transition from its cur- cies as a close substitute for planning; they rent approach to managing its port folio consequently often prefer large-scale invest- of state enterprises to an approach that is ments by SOEs instead of achieving the same best suited for its long-term development ends through incentives, market forces, and objectives? private sector initiatives. Industrial policy ini- The response to the first challenge is tiatives by different departments can some- straightforward. Public resources should be times conflict and interact with one another, used solely or mainly for the provision of making the overall policy framework compli- public goods and services, the production cated and opaque and the results ambiguous or consumption of which result in unre- and unpredictable. munerated positive externalities. These Many studies suggest the potential for goods and services range from defense at significant growth dividends from giving one end to infrastructure, social protec- the private sector a greater role in compet- tion, and basic R&D at the other, and their ing with state enterprises in key sectors. The scope could evolve as conditions change. greatest benet i fi s likely to accrue in so-called The recent emphasis on public housing for “strategic” sectors where competition has the poor is a good example of how govern- been curtailed. In 2006, China identified ment resources can be used to address a over vie w 27 pressing social need. Indeed, the scope of important that key principles are established public goods and services can be quite broad, early. It is critical, for example, that the State- and can even include reliable energy supplies Owned Assets Supervision and Administra- and the widespread availability of commu- tion Commission (SASAC) confine itself to nications and postal facilities. The share of policy making and oversight, leaving asset public resources applied in a particular area management to the SAMCs. The SAMCs will depend on the nature of the public good should have clear mandates, be indepen- or service being supplied. In areas considered dently and professionally managed, and be to be of high national priority, like defense, subject to publicly announced performance government resources would be expected to benchmarks (depending on the nature of provide the full or dominant share of finance. the enterprises in their portfolio). In addi- But in most areas, a smaller share is usually tion, they will need to adhere to international sufficient to achieve the government’s objec - standards for transparency, including on tives. Most important, in many cases, private operations and results, value creation, prot fi - sector firms will be fully capable of deliver - ability, and dividend payments. ing public goods and services, even though More competition—domestic and inter- the government may provide the bulk or national—will be key to improving the effi - some part of the finance. The private deliv - ciency and innovation capability of Chinese ery of public goods and services (with public enterprises. To increase competition in financing) introduces the added dimension of domestic markets, further reforms will be competition and helps lower production and needed to support private sector firms, such distribution costs. as lowering barriers to firm entry and exit, The response to the second question is breaking up state monopolies or oligopolies less straightforward. First, the government in key industries (petroleum, chemicals, elec- could securitize its implicit equity in state tricity distribution, and telecommunica- enterprises as soon as possible (in listed state tions), promoting the growth of dynamic enterprises, the value of the equity is already SMEs and increasing their access to finance, known). This would pave the way for state stimulating much needed regional and local enterprise reform by separating ownership specialization, and encouraging spontaneous from management and introducing mod- state enterprise reforms through competi- ern corporate governance practices, such as tion. China’s own past experience, together appointment of senior management, public with that of other countries, shows that disclosure of accounts in accordance with increased domestic competition can result in international practice, and external audit- significant improvements in productivity. ing. Second, the government could consider With these reforms, state enterprises can, establishing several state asset management over time, withdraw gradually from contest- companies (SAMCs) that would represent able markets. Starting in the late 1990s, for the government as shareholder and would example, ownership diversification and mar - professionally manage and trade these assets ket reforms stimulated entry and competi- in financial markets where feasible. Each tion in most manufacturing subsectors. Even SAMC could specialize in certain sectors. in some strategic or pillar industries, such as They could then, on behalf of government, telecommunications, the breaking up and gradually diversify the portfolio over time. corporatization of incumbent enterprises The dividends of state enterprises would need created new competitive forces. Easing the to be paid to the SAMCs who, in turn, would entry of private firms into these areas and transfer them to the budget. Finally, a por- giving them access to adequate levels of tion of state assets could be transferred to finance from state-owned banks will further the national pension fund with the flow of promote efficiency and competitiveness. returns being used to help meet future pen- And with an eye to redefining further the sion obligations. role of government, policies should encour- While the operational details of the pro- age the private provision of public services, posed SAMCs can be elaborated later, it is and public procurement should be further 28 c h i n a 2030 opened to competition by private firms. remains repressed and suffers from key struc- Where natural monopolies exist (for exam- tural imbalances. The current system, char- ple, in rail services), the monopolist enter- acterized by dominance of state-owned prise should be subject to independent and banks, strong state intervention, and remain- strict oversight to ensure that the lack of ing controls on interest rates, has been competition does not lead to monopoly pric- remarkably successful in mobilizing savings ing and the abuse of market power that could and allocating capital to strategic sectors dur- harm downstream industries. Further efforts ing China’s economic take-off. Going for- are also needed to level the playing field, ward, however, such benet fi s are increasingly especially between smaller and larger firms, likely to be outweighed by many costs. The and between state and nonstate firms—with first cost is the disintermediation of the non - a special focus on laws and regulations, and state sector, especially micro, small, and access to credit from state-owned banks. This medium enterprises that have significantly will also require review and modernization less access to formal financial institutions of China’s “industrial policies” to support than state enterprises and large firms. Sec - the growth of firms in dynamic new sectors, ond, low lending rates have contributed to improve resource allocation, and stimulate excessive investment and high capital inten- innovation. sity. Third, the government’s important role In addition, competitiveness and inno- in credit allocation at the central and provin- vation will be encouraged by measures to cial levels is leading to the accumulation of enhance international competition through contingent liabilities not easily quantified further integration with the global economy owing to limitations on monitoring, data col- (see chapter 8), and a reduction in behind- lection, and interagency data exchange. And the-border barriers to trade. China’s acces- fourth, the financial system is growing more sion to the World Trade Organization in complex—markets and institutions are 2001 triggered economy-wide improvements increasingly intertwined across borders, and in efficiency and spurred technology acquisi - informal credit markets, conglomerate struc- tion and adaptation. More recently, the phas- tures, and off-balance-sheet activities are on ing out of incentives that had favored foreign the rise. investors stimulated competition by leveling Not only do the above characteristics of, the playing field with domestically owned and trends in, the financial system pose sig - firms. nificant systemic risks, they will eventually prevent China’s financial system from serving an increasingly dynamic, sophisticated, inter- Factor Market r eforms nationally integrated economy, driven, in To complete the transition to a market econ- large part, by private sector firms. Banks, omy and further strengthen its foundations, capital markets, and other financial interme - diaries will need to raise and allocate capital China needs to also focus attention on factor efficiently; adopt modern corporate gover- markets—capital, land, and labor—where market reforms have tended to lag, and con- nance arrangements; provide access to micro, sequently, the remaining distortions are par- small, and medium borrowers; assess and ticularly large. Price, regulatory, and insti- manage risks using best-practice techniques; and provide a broader variety of financial tutional changes are essential to ensure that resources flow to economic activities that services to an increasingly diversified clien - yield the highest returns. tele. At the same time, an increasing number of Chinese enterprises will go global, placing pressure on China’s domestic financial sys - Capital tem to adopt global standards to ensure Despite impressive progress in reforming and seamless integration with foreign financial deepening the financial sector in the past institutions and global capital markets. Ris- three decades, China’s financial system ing income and accumulation of wealth over vie w 29 within China will increase the demand for and using interest rates, rather than credit new financial products and investment ceilings, to manage liquidity. Commercial opportunities. And finally, in the event of banks would use commercial principles financial crises emanating from inside or out - and creditworthiness analysis, rather than side China, adequate systems (including ade- follow government signals, to guide lend- quate capital buffers and clear accountabili- ing (an exception could be made for one ties) will need to be in place for an orderly or more policy banks that would continue and systematic resolution of bad debts and to finance government priority programs). either the recapitalization or the closing of Such reforms may require a thorough over- insolvent financial institutions. Instead of haul of governance structures in state- persisting in pushing problems into the owned financial institutions, in which exist - future, financial sector reforms in the next ing state ownership functions, agencies, and two decades should be decisive, comprehen- practices are reviewed, using lessons from sive, and well coordinated. examples of international best practice and The aim of financial sector reforms should failures. In addition, efforts should be made be to build a competitive, balanced, efficient, to further diversify the ownership structure safe, and sound financial system that meets in state-owned banks and further reduce the demands of the corporate, household, the shares held by the state. and government sectors. A well-functioning Second, although its huge foreign reserves financial system capable of sound risk man - give China a strong safety net against the agement is essential to mobilize savings; possibility of a financial or currency crisis, allocate capital efficiently to an increasingly it nevertheless must be prepared in case a complex and sophisticated economy; and crisis occurs. To achieve this, the govern- ensure access to finance for all sections of the ment needs to strengthen the independence, economy including individuals, households, effectiveness, staffing, and funding of regu - the poor, and businesses of all sizes. latory bodies, including supervisory agencies To reach these objectives, financial sec- (at the central and provincial levels), and to tor reform should follow an implementation give them greater enforcement and resolution road map that is properly sequenced, and, powers. A high-level financial committee on because the financial sector will remain vul - the basis of the existing framework could also nerable to crises, be sustained as a priority be established, with the main objective of through the next two decades. Much has monitoring and managing systemic risk and been learned from China’s own experience maintaining financial stability. Limits need as well as the successes and failures of other to be placed on emergency liquidity support countries that have sought to reform their to solvent banks facing short-term liquidity financial sectors. problems. Standing facilities should operate The first priority should be to make inter - automatically to provide liquidity support to est rates more flexible, and endeavor to move all domestically incorporated institutions, to a point where interest rates, not quantity and clear guidelines should govern and limit controls, clear the credit market. In addi- the use of fiscal resources. Stress testing tion, greater exchange rate flexibility is should be continued and improved to take needed to help cool inflation and take pres - account of emerging risks, and “financial sure off reserve requirements, together with war games” should be conducted regularly the deployment of a combination of mon- to fine-tune the institutional arrangements etary and macroprudential measures to pur- for dealing with a financial crisis if and when sue growth, inflation, and financial stability one occurs. The government should estab- objectives. lish an efficient legal framework; insist on In parallel, direct and indirect controls higher standards of disclosure, auditing, and of financial institutions must give way to accounting; and streamline the court sys- arm’s-length market-based arrangements. tem to deal with troubled banks and firms This would mean an autonomous central in a timely fashion. A functioning deposit bank adopting open market operations insurance scheme to underwrite risks faced 30 c h i n a 2030 by small depositors should be established. Land Such arrangements will not only help ensure Over the next 20 years, land will be increas- financial stability but also provide the cred - ingly scarce, and its efficient use will become ible foundations for the eventual integration critical for a range of China’s long-term of China’s financial sector with the global objectives—food security, efficient and inno - financial system. vative cities, equality of opportunity, and Third, the capital market will need to social stability. Better land policies will help be deepened and reformed to make avail- secure farmers’ rights over land use and pro- able more equity and securitized financing, mote agricultural investments and productiv- an important ingredient for more dynamic ity; ensure that land is used for the highest and innovative industries. To achieve this, productive purposes, whether in urban or China could shift the way it handles initial rural areas; help reduce rural-urban inequal- pubic offerings from the current merit-based ity; and promote more efficient and sustain - approval system to a disclosure-based system able urban development. and focus on improving the capital market’s Policies affecting land face three key chal- legal framework, enforcing laws and regula- lenges. The first challenge is insufficient tions, upgrading the financial infrastructure, security of rural land tenure. Despite a rela- and imposing stringent rules on information tively clear legal and policy framework, rural disclosure. Adequate and accurate disclo- households continue to possess weak land sure and transparency supported by credible rights and often face expropriation risks. In accounting and auditing practices can go a addition, serious difficulties remain in the long way in supporting financial development implementation of policies and laws, gover- by minimizing informational friction. China nance and accountability at the local level, could also promote the corporate bond mar- documentation of land rights, and increasing ket, which would not only open up new citizens’ awareness of existing rights. channels of financing and further diversify The second challenge lies in the process financial markets but also create conditions of converting rural land for urban use. Dur- conducive for further liberalization of inter- ing 2003–08, the government requisitioned est rates, the opening of the external capital 1.4 million hectares of agricultural land for account, and internationalization of the ren- urban use, and another 450,000 hectares minbi. Financial infrastructure needs to be were reported to have been requisitioned further upgraded to facilitate transactions in In China, the government has illegally. the financial market in general and the capi - unusually wide powers by international stan- tal market in particular. dards to requisition agricultural land for Fourth, after the above institutional and urban use. The exercise of this power has led governance structures are in place, the Chi- to four consequences: the government has nese authorities can also prepare and imple- reserved for itself the sole right to requisi- ment a plan that phases out the ceiling on tion agricultural land for urban purposes; the deposit rates and the floor supporting lending acquisition price of the land is its net pres- rates; this step will facilitate the commercial- ent agricultural value, not the (usually much ization of banks and ensure stability in the higher) market price of land, which is its financial sector. And as is actually well rec - opportunity cost; local governments, which ognized and understood in China, this final acquire land at the acquisition price and then stage of interest rate liberalization will have sell at the market price, have come to rely on to be properly sequenced—long-term mar- land acquisition as a revenue earner to finance ket instruments first, and short-term deposit the delivery of public services, especially rates last. Careful monitoring of the progress infrastructure; and the consequent rapid of liberalization will be crucial to ensure that growth of urban boundaries has resulted in banks do not indulge in destabilizing compe- urban sprawl (figure O.4). The lack of trans - tition that erodes margins or in reckless lend- parency in land acquisition and the large dif- ing that harms the quality of the loan portfo- ference between the price paid to affected lio, and that any emerging risk of distress is dealt with swiftly. farmers (after a portion is held back by the over vie w 31 FIg Ur E O.4 Urban land has expanded faster than urban population collective) and the price received when the land is auctioned has led to a sense of injustice Physical expansion of Chinese cities and population growth, 1995–2008 and been a factor in increasing rural unrest. The third challenge is the use of land as 20 Shenzhen a source of revenue for some local govern- ments and collateral for borrowing by special purpose vehicles established to circumvent Nanjing Guangzhou restrictions on local government borrowing. Beijing 10 Chengdu Revenues from land acquisition now consti- Average tute a significant share of total government Shanghai Shantou Wuhan Shenyang revenues and have become an indispensable 5 Xi’an funding source that local governments use to Tianjin finance heavy expenditure requirements. In addition, thousands of special purpose vehi- 0246 810 12 14 16 18 20 cles have been established (by one measure Annual % growth in city population more than 5,000) that use local government Source: NBSC, various years; World Bank staff estimates. land as collateral to raise funds from the Note: The green line is the line of equality. The black line is the linear regression between banking system. The National Audit Office the two variables. The blue circles are China’s 11 largest cities. estimates that local-government-related debts exceeded RMB 10 trillion by the end of 2010, of which a significant share were deemed to that the Communist Party’s 2008 Policy be nonperforming. Decision regarding this issue be enshrined in Meeting these three challenges will require law soon. The law will need to clarify who a mix of policy reforms and institutional will be eligible for such rights; what the resid- development that will take time to design and ual role of the collective will be; the actual implement but that is essential for the success terms of the document that grants land user of the reform program as a whole. Without rights (a common title document used nation- these reforms, agricultural investment could suffer, rural-urban inequality could continue wide would be ideal); and the rights and to rise, urban sprawl could stymie environ- responsibilities of land users as well as sanc- mental and economic goals, and the effi- tions in case of violations. ciency of land use could decline. Effective implementation of land user The first priority is implementation of rights will require some degree of clarity measures that ensure the security of agri- about the land’s location and delineation. cultural land tenure, including rolling out Over the coming years, various land registra- the recent policy decision to grant indefinite tion pilots need to be scaled up. Lessons from land use rights to farmers, expanding land other countries indicate that placing land reg- registration and strengthening rural land istration and administration of the land regis- markets, and reforming and modernizing the try under a single agency is the most efficient, governance structure of rural collectives and because such an arrangement avoids overlap- dispute resolution mechanisms. A second pri- ping and competing jurisdictions. Developing rural land markets will greatly ority involves reforming land acquisition and assist in improving the efficiency of land use. compensation practices, including strategic The transition to transparent and efficient land use planning at the municipal, regional, rental markets for user rights can potentially and national levels. A third priority involves substituting property and other local taxes raise productivity by 60 percent (Jin and for land requisition as a revenue source as Deininger 2009) and facilitate labor mobil- well as allowing local governments to bor- ity and land consolidation. Such markets row from domestic capital markets subject to have developed rapidly since the 1990s, (they strict controls and regulations. now cover about 20 percent of cultivated In rural areas, the government could begin land), but the absence of enforceable con- by legally granting farmers indefinite user tracts continues to inhibit growth, and most rights to land they cultivate. It is important transactions remain informal. Expanding Annual % growth in built-up area of city 32 c h i n a 2030 such markets will require improvements in In addition to revenues from land acqui- land registration and documentation (and the sition, some local governments have also latest land-mapping technologies make this become increasingly reliant on resources cost-effective) as well as the establishment raised by land banks that use land as collat- of credible and trusted dispute resolution eral, and, as recent events have shown, this mechanisms. practice may lead to significant financial Governance standards in rural collec- losses and transmit these risks to the broader tives need improvement. One of the key banking system. The challenge lies in replac- causes of land insecurity in rural areas is the ing these socially and financially costly forms abuse of power by some village cadres at the of raising revenues with a more efficient and expense of the members of the collective. sustainable revenue base. Over time, other Land re adjustment or sales are often under- revenue sources, including a property tax, taken in collusion with commercial develop- may help make up the difference (see chap- ers with little transparency or accountability. ter 7). A few countries, such as the United Although the frequency of such events may States and Canada, raise 3–4 percent of their have declined, one survey showed that every GDP from property taxes, while the aver- village experienced at least one reallocation age among members of the Organisation for during the period 1998–2008 (Wang, Tao, Economic Co-operation and Development and Man 2010). Going forward, and espe- (OECD) is near 2 percent. China is already cially in light of the policy supporting indefi - piloting property taxes in two cities but is nite land use rights, the role of the collective finding that its introduction is usually dif- will need to be reexamined, with a view to ficult for technical, institutional, and social improving governance standards. reasons. This argues for its gradual introduc- Policies governing acquisition of rural land tion and for modest expectations about its for urban use need to be overhauled. Because contribution to revenues. the state has used its untrammeled acquisition authority to raise revenues, the urban land Labor area in China has grown much more rapidly than the urban population. Two reforms are Just as land and capital need to be used needed: First, local governments should be where they provide the highest returns, so allowed to acquire rural land for urban areas too should labor be allowed to move to where only if the urban development plans have the most productive and best-paying jobs been vetted and approved by a higher level of are. But China’s hukou, or household regis- government, and the approval process should tration, system and its locally administered take into consideration regional land area insurance and pension systems make mobil- priorities and urban land use efficiency. Sec - ity difficult. In addition, the labor force is ond, the current practice of compensation— expected to start shrinking in a few years, a frequent cause of complaints—needs to be and a declining labor force participation reviewed. One approach would be to pay the rate among older workers is likely to make going market price to the collective (with total this downtrend worse. Together, these two pass-through to the farmer) but then impose constraints threaten to undermine China’s a transparent capital gains tax. The current efforts at becoming an innovative and inter- practice of expropriating the entire difference nationally competitive economy. To compete between the agricultural value of the land against advanced economies in global mar- and its urban market value is equivalent to a kets, China will need a more flexible and 100 percent capital gains tax; a lower figure dynamic workforce that can adjust quickly to would be a reasonable compromise between changing market conditions. In the Republic the need for more local government revenue of Korea, some 45 percent of the population and some benet fi s for the farmer whose land migrated across provincial boundaries, con- is acquired and way of life changed forever. tributing to extraordinarily rapid urbaniza- Part of the capital gains tax revenue could be tion, concentration of economic activity, and used for rural development within the county flexible reallocation of labor; in China’s where the land is located. case, 19.5 percent of the population migrated over vie w 33 in 2010; nearly 85 percent of the migrants owing to fiscal constraints, have progressed moved from rural to urban areas. least in large cities where rural migrants are Over the coming decades, notwithstanding most concentrated. In contrast, migrants to a decline in China’s overall labor force, hun- small and medium cities receive a modicum dreds of millions will move in search of bet- of social services and social protection. Tak- ter jobs, and their absorption will require ing these factors into account, a systematic labor markets that are flexible and institu- approach to propel hukou reform forward tions that protect workers by providing some would include: (1) delinking the hukou from employment predictability, social security, access to public services and using a residen- and portable rights to affordable health care tial permit instead to determine eligibility to and financial security in their old age. Gov - receive services; (2) encouraging pilot reform ernment leadership will be crucial in helping programs at the local level; and (3) redefining people obtain equal opportunities to access financing responsibilities between central and jobs, education, and health care services, and local governments as an incentive for reform. to manage rising risks stemming from further To increase the labor force participation structural change, difc fi ult global conditions, rate, especially among older workers, the and increased competition. Developing a ex fl - government could increase the retirement age ible and dynamic labor market will be central of men and women, which has the additional to China’s future success as a high-income, benefit of reducing the burden on pension open economy; whether that can be done will systems (see chapter 6). Many OECD and depend critically on whether production and transition countries have tried this in recent employment patterns adjust quickly to chang- years, with the annual increase in the retire- ing demand conditions globally and domes- ment age ranging from six months a year in tically. Phased reforms of the hukou system transition countries to one to three months to ensure that, by 2030, Chinese workers a year in OECD countries. The government can move to where the jobs are; measures to could also promote flexible working arrange - increase labor force participation rates; and ments and strengthen mid-career training reforms in labor taxation, hiring policy, and and life-long learning opportunities. wage policy will all be essential to success. China should also reduce the level of Hukou reform will be a top priority in social insurance contributions required for the coming decades and needs to be com- employed workers. This implicit employment pleted by 2030, but progress will likely be tax imposed on employers, amounting to slow because it will depend on fiscal reforms. about 45 percent of the wage rate on average, The hukou system no longer restricts move- is high by international standards. Because ment of labor from rural to urban areas. minimum contributions are set at a rate But rural migrants without urban huk- applied to 60 percent of the average wage, the ous are still denied access to social entitle- implicit tax rate is much higher for workers ments—health care, education, and hous- earning low wages. Employers therefore avoid ing—that urban residents receive. One of formalizing employment. Many employers the key constraints to hukou reform is that and employees also “opt out” of social insur- local governments have neither the resources ance schemes. The total number of contribut- nor the incentives to extend public services ing urban workers in 2010 ranged from 237 to migrants and their families. So the speed million for health insurance and 236 million of hukou reform will depend on the rapid- for pensions, compared with only 134 million ity with which local governments strengthen for unemployment insurance and only 80 mil- their fiscal systems (see chapter 7) and how lion for housing funds. financing responsibilities are shared between Finally, China’s public sector entities central and local governments. The inability should be “equal opportunity employers,” to provide migrants social entitlements on that is, their recruitment practices should be par with urban residents not only increases transparent, based on merit, and impose no inequality but also discourages mobility. restrictions on place of birth or possession of Local hukou reforms have been ongoing but, an appropriate hukou. 34 c h i n a 2030 Chapter 4 Increasing the Pace of Innovation Notwithstanding reforms in factor markets Even so, much will depend on complemen- and development of the private sector, sus- tary domestic reforms and the global envi- taining high growth poses a considerable ronment—merely investing another 1 percent challenge. With population growth slow- of GDP in research and development will be ing sharply and investment rates also set to insufficient. Many complementary ingredi - decline, growth will be more dependent on ents in China’s innovation policy, including gains in total factor productivity. During the private sector development and increased past decade, TFP growth averaged 3 percent competition, reforms in factor markets, adop- a year, which is high by international stan- tion of a green growth strategy, human capi- dards and attributable in large part to rapid tal deepening, and the effective harnessing of structural change; product and process tech- urban agglomeration economies to advance nology spillovers from high levels of foreign ideas and technologies, are discussed in other direct investment; the speed of technologi- chapters of this report. This chapter focuses cal catch-up made possible by the buildup on policy reforms needed to develop a system of physical, human, and financial capital; of incentives and institutions that could spe- the progressive easing of infrastructure con- cifically support broad-based, economy-wide straints; and the creation of a more competi- innovation. tive and open economy. The potential productivity benefits from Innovation Advantages catching up in industry and services, from measures to enhance competition in the As it begins its journey toward an innova- domestic market, and from the accumula- tive economy, China possesses several advan- tion of human and knowledge capital, are far tages. First, China’s spending on research from exhausted. But there can be little doubt and development is on a steep upward trend. that many segments of Chinese industry are Second, China’s manufacturing sector is approaching the technology frontier, that large and possesses wide-ranging capabili- intersectoral transfers of labor will dimin- ties. Third, having expanded its education ish, and that the contribution of capital as system, China’s efforts to innovate are being a growth driver will decline. Recognizing supported by a rising supply of science and these facts, China is turning to innovation as engineering skills of improving quality. a means of achieving rapid and sustainable Fourth, an elastic supply of patient capital is growth while coping with looming challenges being mobilized to support innovative firms associated with resource scarcities, climate and scale up the production capacity of new change, and environmental degradation. entrants with good ideas. Fifth, China’s large Is innovation the answer? Over the long and expanding market of urban middle-class term, high levels of investment will remain consumers—expected to double in the next a major driver of growth in China through decade—is attracting leading innovative embodied technological change, but its multinationals, encouraging local innova- importance is likely to decline while TFP tors, allowing domestic producers to attain growth from innovation is expected to scale economies, and permitting formation become increasingly significant. Were invest - of clusters and agglomerations. Sixth, a pro- ment to fall to European levels of around 25 business, entrepreneurial culture in several percent of GDP or less, growth would trend of China’s provinces, including Guangdong’s toward 4–5 percent a year. But a more inno- Pearl River Delta, Zhejiang, and Fujian, is vative China that continues to invest at least supportive of small firms and start-ups. Sev - a third or more of its GDP has a high prob- enth, considerable potential is inherent in ability of meeting its growth targets buoyed China’s relatively underdeveloped services by above-average advances in TFP. sector. Eighth, and finally, not only is China over vie w 35 urbanizing, some Chinese cities are realizing innovation efforts within a competitive mar- that the productivity and growth of urban ket system. economies will rest upon the quality of life The central government will need to take and how effectively these cities can attract greater initiative in building countrywide and retain global talent. research networks that mobilize national tal- ent and reduce the isolation of firms in some cities by including them in research consor- Innovation Weaknesses tia that also involve advanced firms (includ - China’s rising supply of skills and its large ing multinationals) from coastal cities. The and advanced industrial base notwithstand- governments of Japan and the United States ing, the reality is that government and state have successfully sponsored such consortia enterprises conduct the bulk of research and in their countries; similar efforts in China development—and part of this effort still could potentially develop more “global chal- seems divorced from the real needs of the lengers.” These domestic networks can also economy. True, China has seen a sharp rise link to global R&D networks in ways that in scientific patents and published papers, leverage Chinese efforts with research activi- but few have commercial relevance and even ties in other parts of the world. The natu- fewer have translated into new products or ral inclination may be to protect domestic exports (the honorable exception being tele- research efforts and innovative companies, communications and consumer electronics). but that would prevent Chinese research- Part of the problem may lie in weak incen- ers from interacting with external research tives for indigenous, government-backed efforts, cut them off from new ideas, and research institutes to work with commer- lower opportunities to adopt foreign technol- cial users of new technologies. In addition, ogies. Links with global networks would also research institutes may not be capturing help address constraints in domestic research opportunities to leverage their capabilities capacity and overcome perceptions in foreign by networking within the country and con- countries about China’s research and devel- necting with global R&D networks. China opment program. Moreover, the trend in has the potential to improve the institutional global R&D is rather similar to other kinds arrangements needed to encourage broad- of economic activity, such as increased spe- based innovation—such as ease of firm entry cialization, more intense exchange of ideas and exit, increased competition, enforce- and know-how, and frequent exchange of ment of laws protecting intellectual property research personnel. In such a model, China rights, quality tertiary education, the avail- will be a participatory member in a global ability of risk capital for small and medium research effort in which it is a consumer as enterprises, evaluation of government R&D well as a producer of new ideas, new inven- expenditures, and standard setting in gov- tions, and new ways of doing business. ernment procurement. In the long run, the Many high-tech multinational corpora- objective should be to develop a system tions have invested in R&D facilities in China that stimulates broad-based creativity and (including in inland cities such as Xian and innovation. Chengdu). Such investment should be further encouraged because of its significant spill - over effects, the reputational gains for those Key r eform r ecommendations Chinese cities that are fast becoming science A better innovation policy in China will hubs, and the contribution this research can begin with a redefinition of government’s role make to industrial upgrading. Closer collab- in the national innovation system, shifting oration and partnerships with multinationals away from targeted attempts at developing on the basis of mutual trust and recognition specific new technologies and moving toward will contribute to the creation of a dynamic institutional development and an enabling and open innovation system. In this con- environment that supports economy-wide text, an efficient patenting system that re- 36 c h i n a 2030 flects the experience of the U.S. and Euro - located in interior provinces, and permit ven- pean systems (both of which are in the ture capital owners an exit option. Finally, throes of reform) and effective protection of governments could help innovative SMEs by intel lectual property, especially in fields such establishing public technology platforms that as biotechnology, nanotechnology, software, provide SMEs access to laboratory, metrol- and multimedia, will expedite the growth of ogy, testing, and certification facilities. China’s innovation capabilities. Then there is the direct role of govern- China’s innovation policy needs to reflect ment in R&D. Central and provincial gov- the lesson borne from international experi- ernments are seeking to enlarge spending ence that most applied research and innova- on R&D and also raise the share of basic tion is done within large private sector firms. rese arc h supported by universities and Large private firms tend to make innovation a research institutes. Support of basic research central plank of their competition strategies, is more likely to succeed through well- respond to market demand and government targeted incentives, by committing a sufc fi ient incentives, and provide researchers with the volume of funding to a few high-caliber insti- freedom to pursue interesting ideas and inter- tutions, and by sustaining that funding. One act with other researchers both at home or example is the National Institutes of Health abroad. A range of incentives—through fis - in the United States, which plays a central cal, financial, and regulatory instruments— role in boosting innovations in life sciences needs to be applied to encourage such firms to because it enjoys large and stable funding. emphasize research, development, and inno- Another is the Defense Advanced Research vation, and to give them a large enough mar- Project Agency, also in the United States. ket to ramp up production of new products To maximize spillovers from government- and achieve economies of scale. In addition sponsored research, findings would need to to tax deductions for R&D spending, these be made widely available. Beyond that, it is incentives could include temporary consumer up to firms to transform the research findings subsidies for the purchase of new products into prot fi able products and services. that have proven positive externalities (such But increasing R&D spending to the as electric automobiles, for which China is government’s target of 2.2 percent of GDP, already providing consumer subsidies). expanding basic research, and emphasizing At the other end of the size spectrum, publishing and patenting is likely to have SMEs should also be seen as an important only a small impact on productivity growth, source of innovation, especially in sunrise unless the quality of this research and its industries. SMEs, after all, are the big commercial relevance and uptake are sub- firms of the future, and every effort should stantially increased. Good research must be be made to ensure they are not disadvantaged complemented by a stringent and disciplined by regulations and are encouraged through process of refereeing and evaluating research tax incentives. Innovative new entrants, espe- findings. The research community needs to cially SMEs, face a perennial shortage of risk take the initiative here, although the govern- capital. True, local governments and state- ment could provide the parameters. owned enterprises are increasingly becoming China’s innovation objectives, increased sources of venture capital and private equity effectiveness of its basic research, and funds. Nevertheless, venture capital is scarce development of high-technology industries for smaller private firms and SMEs trying to en visaged in the 12th Five Year Plan all scale up. One partial solution is to increase depend on the availability of a vast range lending by banks to small, hi-tech, private of technical skills for research, design, fab- firms. The resulting creation of bank-led rication, production, information and com- relational networks seems to work in other munication technology (ICT) support, and countries, such as the United Kingdom and eventually marketing. By 2030, China is the United States, and complements other expected to have up to 200 million college sources of financing. Another approach is to graduates, more than the entire workforce ensure that capital markets both allow SMEs of the United States. Moreover, the quality access to funding, even though they may be of university training is improving rapidly: over vie w 37 FIg Ur E O.5 The quality of China’s tertiary education system is improving rapidly Top 500 universities in the world, 2010 Source: Shanghai Jiao Tong University 2010. a. The United States, which has 154 top universities, is not shown. in 2010, only five countries had more uni - qualifications, and do away with the rigid versities than China in the top-ranked 500 boundaries that separate academic streams universities of the world. China had 22 uni- from technical and vocational education and versities in this list in 2010, compared with 9 training. To achieve the desired increase in in 2003 (figure O.5). the volume and quality of skills and maxi- Even so, the quality of tertiary educa- mize the returns from the limited supply of tion more broadly is a matter of concern, quality instruction and teaching facilities, and employers are experiencing a serious China will also have to rely more on inno- shortage of skills. To address this shortfall, vations in ICT and pedagogical techniques China needs to further accelerate governance involving the greater use of multimedia and reform in universities, giving them greater flexible online training customized to the autonomy while, at the same time, tighten- varying needs of students. The traditional ing ethical standards in research. The best education approach of lecturing to large universities must be allowed to mobilize classes may need to be rethought, with insti- funding and appoint faculty that ensure high- tutions being encouraged to experiment and quality, cross-disciplinary, postgraduate, and given the autonomy to do so. Universities postdoctoral programs. They also need to can also take the lead in promoting public develop innovative approaches to imparting lectures and exhibitions and in contributing knowledge and analytical skills and set up to the teaching of science in local schools. In well-staffed specialized research institutes. this context, opening the tertiary education In this regard, China should encourage lead- sector to foreign investment and increasing ing foreign universities to set up campuses in the participation of leading foreign univer- China jointly with domestic universities and sities in China may help stimulate domestic impart modern governance standards, teach- university reforms. ing methods, and research management. There is also scope for encouraging inno- In addition, both the private sector and vation through demand-side instruments the government need to invest more in such as government procurement and stan- improving the quality of human resources. dard setting. The key to success will lie in Public-private initiatives can secure and genuine open competition. One way to begin replenish the base of technical skills essen- would be to take EU or U.S. standards as tial for innovative industries. The education a technical starting point while looking system should emphasize competencies, not for ways to advance product performance; Germany United Kingdom Japan Canada China 2010 France Italy Australia Netherlands Sweden Korea, Rep. Spain China 2003 Switzerland Israel Taiwan, China Austria Belgium Finland Brazil Hong Kong SAR, China New Zealand Denmark Norway South Africa Ireland Russian Federation Greece Saudi Arabia Indonesia Singapore Poland Portugal Chile Hungary Mexico Argentina Czech Republic Turkey Iran, Islamic Rep. Slovenia Number of universities 38 c h i n a 2030 another would be to involve industry leaders application of ICT in health care manage- when setting standards. A third would be to ment, and institutional arrangements for get industry associations to develop industry health care management and financing; and standards based on consensus. •  Green development—including the devel- Technological capability is more likely to opment of more-economical renewable advance in innovative cities. In the past three energy sources and new green technolo- decades, coastal cities served as the incuba- gies, as well as the application of incentive tors of technology development by attracting structures to change behaviors and encour- large levels of foreign direct investment. But age green consumption. industrial cities are not the same as innova- tive cities. Innovative cities have depth and Sequencing quality of human capital (especially a high share of science and technology workers) as The chapter on economic restructuring high- well as mechanisms that support the genera- lighted the urgent importance of increasing tion, debate, testing, and perfecting of new competition and lowering barriers to entry ideas. Innovative cities have local knowledge and exit for increased efficiency and interna - networks, institutions that support innova- tional competitiveness. These reforms are also tion, an industrial base that employs scien- central in providing incentives for research tific and technological talent, a few major and innovation activities. With more invest- dynamic firms that invest heavily in R&D, ment in R&D, perhaps an equally important and digital networks and online services. priority is to introduce an unbiased and inde- Such cities thrive on the heterogeneity of pendent evaluation system for R&D spend- knowledge workers drawn from all over the ing and current industrial policies supportive country and the world. Moreover such cities of targeted technology development. Such are closely integrated with other global cen- a system would give the government rigor- ters of research and technology development. ous analysis to show what works and what Finally, innovative cities are “sticky” because doesn’t, and where government financial sup - their leading edge in design, assets, attributes, port needs to be reallocated. and governance attracts global talent and Policies that will take longer to implement does not let it go. Industrial cities can become include the institutional arrangements for innovative cities—such as Tokyo, Stuttgart, innovation—university development, estab- Munich, Seoul, Seattle, and Toulouse. But lishment of venture capital financial institu - innovative cities do not have to be industrial, tions, and creation of nationally integrated as Cambridge (U.K.), Helsinki, San Fran- R&D networks linked with global R&D cisco, and Kyoto all show. networks. Many of the reforms will depend International experience suggests that on other areas of the economy, notably fis - innovative cities usually include one or more cal and financial sector reforms, but work on leading research universities that compete these can nevertheless begin soon, recogniz- and collaborate with each other. These uni- ing they will take time to bear fruit. versities must interact with employers to mix As far as outcomes are concerned, once a technical and soft skills as well as impart the sound institutional framework is in place and latest industry know-how. Possible areas of as firms near the international technology research include challenges associated with: frontier, a concerted effort will be needed to strengthen basic research. The success of Chi- •  Rapid urbanization—the development of  na’s innovation policy will depend on how energy-saving building materials, efficient effectively all branches of the research and large-scale public transportation systems innovation network (research institutes, uni- with low carbon emissions, and the infra- versities, central and local governments, state structure needs of intelligent cities; and private enterprises) function together and •  Health care—including basic research  how these efforts are leveraged internation- in science and medicine, biomedicine, ally through global networks. over vie w 39 Chapter 5 Seizing the Opportunity of g reen Development Concerned that past and current economic percent. And although air pollution levels growth patterns are environmentally unsus- may be on a consistent downward trend, the tainable and that the environmental base cost of illnesses from pollution has climbed needed to sustain economic prosperity may as the population ages and urban populations be irreversibly altered, the Chinese authori- and urban incomes grow. ties proposed a new approach toward green Third, green development will help development in the 12th Five Year Plan. The address a wide range of sector-specific plan emphasizes continued rapid growth issues, such as energy security, urban liv- together with ambitious targets for energy ability, agricultural output, and infrastruc- efficiency, natural resource management, and ture constraints. The rapid growth of energy environmental sustainability. This approach consumption has strained domestic supplies is consistent with the concept of green devel- of electricity, raised coal prices, and made opment used in this study, namely, a pattern China increasingly dependent on imported of development that decouples growth from energy. With unchanged policies, China may heavy dependence on resource use, carbon have to import 75 percent of its oil (making it emissions, and environmental damage, and the world’s largest oil importer) and 50 per- that promotes growth through the creation cent of its natural gas by 2030. The efficient of new green product markets, technologies, use and better governance of land will help investments, and changes in consumption reduce urban congestion and sprawl. Improv- and conservation behavior. ing the quality of land and water will help raise agricultural output. Better energy effi - ciency will ease infrastructure constraints, Why a g reen Development particularly for handling coal. Strategy? Fourth, given rising and volatile commod- China should give high priority to green ity prices, lowering the resource intensity of development for many good reasons, both production will improve international com- domestic and international. petitiveness and partially insulate domes- First, new technological opportunities tic prices from fluctuations in international make green development not just a realistic prices. possibility but a potential driver of economic Fifth, while China’s green development growth. If successful, green development will strategy is driven almost entirely by domestic create new business opportunities, stimulate considerations, it will make a significant con - innovations in technology, and potentially tribution to tackling global climate change. make China globally competitive in sunrise China is now the largest energy user in the industries. world and the largest emitter of carbon diox- Second, quite apart from stimulating ide emissions, although its cumulative emis- growth, green development would signifi- sions remain significantly below that of the cantly improve the quality of China’s eco- United States (Baumert, Herzog, and Pershing nomic growth. For example, less production 2005). Its annual per capita emissions have and use of fossil fuels would greatly reduce already exceeded the world average and are health losses from air and water pollution, still rising rapidly. Furthermore, China is one water scarcity, and land subsidence. The of many countries that are likely to be most costs of environmental degradation and seriously affected by climate change. Vigor- resource depletion in China are estimated ous implementation of a green development to approach 10 percent of GDP, of which air strategy will not only benet C fi hina but also pollution accounts for 6.5 percent, water pol- contribute toward global efforts to reduce lution 2.1 percent, and soil degradation 1.1 emissions and mitigate climate change. 40 c h i n a 2030 g reen Development as a China’s Many Advantages Source of g rowth in Moving toward g reen Development There are also many reasons why green devel- opment can be a potential driver of growth. By some measures, China’s quality of growth The first is the greening of traditional sec - has shown improvement in the past two tors. A large number of existing conventional decades, although it has a long way to go. techniques and management models can For example, although its energy efficiency both reduce energy use and emissions and improved faster than that of any other coun- improve the level of corporate profitability. try, it is still one of the least efficient energy Although the greening of traditional sectors users in the world. The share of fossil fuels may seem less dramatic and revolutionary in China’s energy mix has fallen since 1990 than the development of cutting-edge new but is still much higher than that of advanced technologies, it is clear that with information countries. China’s expenditures on energy and financing, many energy-efficient invest - research have been the highest in the world ments are also cost-effective and yield high as a share of GDP, however, and these expen- economic returns. ditures appear to be having an impact. The Second, going green can drive growth efficiency of coal-fired plants has shown through the expansion of emerging green impressive progress, and China possesses the industries, including solar and wind energy, world’s largest capacity for renewable energy together with upstream and downstream generation. It is a world leader in small industries such as relevant equipment manu- hydroelectricity generation, has doubled its facturing and electric vehicle industries. More wind-driven turbine capacity every year since broadly, however, new markets and in centives, 2005, and has become the world’s largest supported by innovation and research, will manufacturer of solar panels. likely stimulate new low-carbon, reduced- Going forward, China can build on this resource, and environmentally friendly tech- progress and on its many strengths and nologies, goods, and exports. In addition, advantages. First, the Chinese leadership has increased public awareness will help shift reached consensus on green development, consumer demand toward green products. and the government’s strong implementa- Third, services will also expand as a tion capability will play an important role complement to new green product markets in facilitating change. Second, China’s rela- and changes in consumer preferences. Not tively low urbanization rate and high level only will the rising share of services in GDP of investment as a share of GDP allows for help reduce the economy’s carbon intensity, a rapid turnover of the capital stock, permit- specialized services are likely to develop ting old technology to be replaced with new that specifically support green development. relatively quickly, thus avoiding the lock-in Examples are ecosystem services, carbon costs associated with old buildings and aging asset management services, carbon trading, infrastructure. Third, it can potentially use and contract energy management. its newcomer status in green industries and Fourth, by anticipating climate impacts technologies to leapfrog current capabilities on agriculture, low-lying coastal areas, and in the advanced countries. Fourth, the size areas vulnerable to extreme weather events, of its domestic market can support rapid green development will promote sustainable achievement of scale economies. Fifth, its growth and development, reduce climate- increasingly educated workforce will provide related risks, and improve investor and con- abundant skilled manpower; this, together sumer confidence. International experience with foreign partnerships and appropriate shows that preventive measures are usually policies and institutions, is likely to acceler- far more cost-effective than ex-post recon- ate the pace of innovation. And finally, its struction and rehabilitation. abundant wind, solar, biogas, and shale gas over vie w 41 resources give it many options to reduce its r ecommended r eforms dependence on fossil fuels and improve its Economic activities are replete with external- energy security. ities and market failures that require govern- ment intervention through market and non- Obstacles to g reen Development market policy instruments. To promote green development and control environmental deg- While China has many advantages that radation and carbon emissions, governments would help it implement a green development must intervene to allow economically and strategy, many obstacles and difficulties environmentally efficient markets to fully also need to be overcome. Most important play their role. among these is the price of energy, water, Applying this principle, the promotion of raw materials, and natural resources, which green development in China will involve five remain distorted to different degrees and do distinct but coordinated policy levers: long- not reflect either the negative externalities term market incentives to encourage enter- associated with their use or their true scar- prises and households to “go green”; better city value. The result is high resource inten- designed and enforced regulations requir- sity in production and associated wastage ing changes in behavior in situations where and pollution. A second and related obstacle market incentives do not work; public invest- is excessive dependence on administrative ments that deliver key environmental goods mechanisms to deal with environmental and services with high positive externali- and natural resource management issues. In ties and that explicitly incorporate climate the absence of market-based mechanisms, risk management; measures to strengthen the government is forced to make decisions local government institutions; and safety net that appear arbitrary and occasionally even schemes to mitigate any short-term negative heavy-handed. At the same time, other fis - employment effects of green development cal and regulatory incentives for environ- reforms. mental protection are either weak or weakly enforced; as a result, pollution and green- Long-term market incentives. A key goal house gas emissions remain high. of using market incentives is to harness the A green development strategy will also creativity and entrepreneurial energy of face implementation and incentive con- China’s private sector and state enterprises straints within government, and may face to protect the environment and turn China’s opposition from workers and enterprises that green industries into an important source of benefit from the current pattern of growth, growth by making them world-class innova- exports, and investment. The strategy will tors and competitors. Market incentives are require coordination across many govern- also the best way to foster efficiency, which, ment ministries and agencies, many of whom in the case of green development, goes beyond may oppose it because it reduces their dis- financial efficiency to include resource use cretionary power to make decisions. In addi- tion, while a green development strategy will efficiency and the reduction of environmental be of considerable long-run benet fi , it will in externalities. the short run conflict with other economic So far, China has mainly employed regu- objectives (for example, meeting employ- lations and edicts to enforce its environmen- ment and industrial targets for the five-year tal and emissions targets. Old power plants plan). Resolving these conflicting objectives have been retired and polluting factories will require job retraining, skill development, closed, with measurable benet fi s in improved and similar policies to smooth the adjustment en vironmental quality. But as the scale and toward the new pattern of green develop- complexity of the Chinese economy and the ment, and will need clear and strong leader- environmental challenge grow, the disadvan- ship from the highest levels. tages of this approach will (indeed, already 42 c h i n a 2030 have) become more apparent. Instead, the high-level talent for innovative firms. New government should consider market mech- entrants will stimulate competition and inno- anisms such as taxes, fees, tradable per- vation; the production of electric vehicles, for mits, tradable quotas, and eco-labeling. In example, should not rely solely on traditional degraded ecosystems, rehabilitation is war- automobile manufacturers. Once such public ranted, especially through expanded pay- policies spur private sector development in a ments for ecological services in poor and eco- green sector, the focus could shift to the next logically important rural areas (for example, vanguard sector. In this way, state invest- upriver watersheds or downriver floodplains). ment can play a key role in spurring private There is no better place to begin than by sector–driven technological innovation. State ensuring that market prices of goods and ser- enterprises, on the other hand—especially if vices reflect the true cost of production and they enjoy monopoly power, are subsidized consumption to society. For example, the implicitly or explicitly, or are favored in any price of oil, water, coal, and other natural way by discretionary government actions— resources should include a tax to reflect the are more likely to hinder, rather than encour- social and environmental costs incurred with age, green innovation. their use. Complementary actions would In the early stages of developing green involve removing direct and indirect subsi- industries, the government could “grow big- dies, raising pollution taxes, and canceling ger fish by adding more water.” During the export tax rebates for high-pollution, high- formative period of green firms, the authori - emissions, and resource-intensive industries. ties could offer temporary tax relief, fiscal (Indeed, export targets for these industries subsidies, preferential land allocation, and should also be curtailed, if not abolished below-market financing. Once these firms altogether.) Mining companies, state and are established, however, such preferential nonstate, should pay royalties for the state- policies should be withdrawn. Any initial owned mining resources they use. These loss in tax revenues will be more than made measures, together with enforcement of the up by later increases. At the same time, if it “polluter pays” principle, will help inter- becomes clear that international competitive- nalize the pollution costs of enterprises and ness is unlikely to be achieved, this financial reflect the true scarcity of the resources they support should be withdrawn. use, as well as reflect their real competitive - Given the global push on climate miti- ness in domestic and world markets. gation, the most effective way for China to Such “no-regrets” policies not only establish itself as a global green technology improve efficiency, they also support sustain - leader is by implementing stringent and effec- able growth. But China’s green development tive policies to reduce greenhouse gas emis- strategy has a loftier objective, which is to sions and to internalize the cost of carbon make green industries a source of growth. emissions in the operating costs of enter- To achieve this goal, industries that use green prises. Stringent emissions reduction poli- technologies should be open to private and cies, achieved through such diverse market foreign enterprises that compete on a level mechanisms as carbon trading, a carbon tax playing field. Public investment should focus on fuels, technology standards, and regional on public goods and services such as basic carbon partnerships, can act as a power- research, appropriate infrastructure (for ful mobilizing force for innovation in green example, smart grids), and a supportive envi- technologies. This, in turn, will help lower ronment for private and foreign investment economic costs associated with improving such as streamlined investment and copyright the quality of the environment and help drive approval and rapid endorsement of new tech- overall growth. nologies and products. The 12th Five Year Plan commits China Because innovation is fundamental to to experiment with a carbon cap-and-trade green growth, the government should fos- scheme to be rolled out gradually and on a ter the conditions for creativity by permit- voluntary basis. As China embarks on its ting new entrants as well as the import of own pilot emissions-trading schemes, it over vie w 43 needs to evaluate policy choices between these standards could open up a huge market price and quantitative instruments under the for green products and usher in a period of guiding principles of efficiency and effective - robust growth in relevant industries. ness. Beyond the more conceptual differ- ences between these two approaches, China Public investment. While the bulk of new can find valuable lessons in the experiences investment in green industries and technolo- of many OECD countries, including exist- gies will be through enterprises, a sound ing and proposed carbon-trading schemes in green development strategy will also require Australia, Canada (Alberta), the European incremental public investments over and Union, New Zealand, Switzerland, Tokyo, above the huge amount the government is and the United States (both national and already doing. While China’s annual invest- state-level schemes). ment in the treatment of industrial pollution is roughly comparable to Europe’s, its total Better designed and enforced regula - expenditure on environmental protection tions. Regulations are an important comple- activities is less than Europe’s by 0.3–1.1 per- ment to market-based incentives to promote cent of GDP. green development, provided the authorities To improve environmental quality over are able to monitor and enforce compliance the longer term, China’s government expen- effectively. One important step will be the ditures related to the environment should be establishment of strong environmental and at least half a percentage point of GDP higher emissions technical standards that will shape than current levels. Incremental expenditures behavior and create market incentives for should be focused not only on reducing pol- green technologies. A key example is in the lution and solid waste but also on protecting automobile industry, where standards can and restoring the health of China’s ecosys- be set for fuel consumption. Another is in tems, water, and soil, and reducing potential the appliance and lighting industry, where damage from flooding. Evidence from other new standards for energy efficiency can countries indicates that such expenditures have a direct and widespread impact, espe- have extremely high economic rates of return. cially given the scale of urban construction. Therefore, a relatively modest incremental A third involves setting national standards increase in environment-related expendi- for climate-robust green buildings, urban tures would go a long way toward reducing design, and transportation to avoid lock- the annual costs of environmental degrada- ing in existing carbon footprints. Compli- tion and depletion (as noted, these costs are ance with these standards can be increased approaching 10 percent of GDP). through tougher inspections and buttressed One of the most important areas for by market-based incentives (such as insur- increased public investment will also be ance policies that require flood proofing or adaptation to climate change and, more compliance with energy efficiency standards). broadly, the development of a climate risk A fourth is the establishment of labels and management framework. Four of the ten standards for green products, services, and Asian cities most vulnerable to rising sea technologies so they are easily recognizable levels are in China. Careful planning and and understood by consumers. And a fifth large public investments will be required to is the implementation of recycling guidelines protect ports, infrastructure, and housing in to reduce the need for new urban landfills these cities from extreme climate events. The or incinerators by reducing the volume of government could invest more in public insti- waste at the source. The government could tutions to analyze and disseminate weather- also signal its seriousness about environmen- related and emergency response information, tal goals by changing the way it conducts and it could also update and develop new its own business. The most important and climate-robust technical standards for infra- pervasive approach would be to introduce structure. Follow-on actions could include green standards for the roughly RMB 1 tril- relocating transmission lines and distribu- lion in government procurement each year; tion systems for power grids in coastal areas 44 c h i n a 2030 exposed to natural hazards, and redesign- bold efforts are under way to deploy clean ing storm water drainage systems in cities technologies, improve energy efficiency, and so they can handle extreme weather events reduce greenhouse gas emissions. But green projected for the next several decades. successes in some areas are not being scaled The government also needs to prepare for up because most local officials remain under climate-induced effects on agriculture and more traditional pressure to grow their econ- to invest early in flood control, water man - omies and protect jobs. agement, drought-resistant plant varieties One way to align national and local objec- and agricultural methods, and research on tives is to introduce explicit performance climate-induced effects on the economy. indicators for local governments that sup- These investments would earn higher port green growth. China could consider economic rates of return if they were using some of the measurable indicators sug- complemented by measures to improve gested by the OECD (2010), along with other water use efficiency (for example, through indicators that have been developed by local consumption-based allocation and trading governments themselves. For example, some of water rights) and expanded pollution reg- subnational governments—typically more ulation that includes coverage of nonpoint affluent ones—have introduced quality-of- sources of pollution. Finally, expanding cur- life indexes into performance appraisals for rent programs that restore forest cover and public officials. Meaningful ratings depend watersheds to meet the objective of restoring on publicly disclosed information, such as on ecosystem health will have even broader the levels of air and water pollution and on benefits. When investing in environmental the levels of environmental compliance across improvements, it is important to use instru- industries. Fujian Province has included ments that give value to environmental qual- ratings for environmental quality, energy ity and then reflect these values in measures consumption, R&D, public safety, education, used to monitor and rank the performance and rule of law in its performance evalua- of local governments. tions. Guangdong Province recently started To mobilize collective action on environ- using a “happiness index” as a supplemen- mental protection and climate change, the tary measure of performance. A national poll government needs to launch mass education in 2011 found an overwhelming 89 percent campaigns to increase public awareness of of respondents in favor of including a happi- these issues and the actions that individu- ness index as part of local government per- als and households can take to contribute formance evaluations (Feng 2011). toward the national effort. China can make Two other important ways to strengthen emissions reduction and environmental pro- local institutions include, first, adjusting tection a desirable lifestyle, thereby increas- the local tax structure away from land sales ing market demand for green products. To and in favor of property and value-added do so, it could mobilize nongovernmental taxes (see chapter 7). Among other benefits, organizations, industry associations, and the greater use of property taxes would pro- media. It can also change consumer behav- vide additional incentives for local govern- ior by providing better information, through ments to increase land values by improving energy efficiency labeling, for example. the local environment. Another step is to strengthen interregional coordination to bet- Local institutional strengthening and ter manage regional transportation, natural reform. In the past, some of China’s most resources, and pollution control facilities. successful reforms, such as the household Urban, transport, ecosystem, and environ- responsibility system, originated as local mental problems are not confined to local experiments that were later scaled up. The boundaries. Incentives are needed to encour- same could be said for green development. age smart urban planning and risk man- In a few cities such as Baoding and Rizhao, agement by local and regional governments over vie w 45 across an entire region. Transjurisdictional Conclusion bodies, such as river basin commissions and Green development can drive growth and regional planning boards need to be given address past environmental deficits, but its more authority. success will take active government poli- cies—applying market and nonmarket pol- Reduce negative impacts on specific sec- icy instruments—together with competitive tors or groups. The introduction of reforms, and well-functioning markets for goods and whether fiscal and financial incentives or services. Valuing natural assets and apply- nonmarket policy instruments (such as new ing a price to pollution will lie at the heart standards and regulations), will inevitably of China’s green growth strategy. Therefore, alter relative prices and change the profit- a key priority would be to price electric- ability of different sectors. Pollution-intensive ity, oil, gas, water, and other key natural sectors will see profitability reduced while resources not only to reflect scarcity value green sectors will see prot fi ability enhanced. but also to incorporate the environmental To handle objections of those likely to costs associated with their use. Enterprises be affected negatively, the government will and households will need to respond to need to be ready with a range of policy mea- price signals and regulatory standards and sures. First, compensation for carbon pricing restrictions. A cap on greenhouse gas emis- (whether through taxation or tradable per- sions together with an emissions trading mits) could be made through fiscal transfers. scheme—combined, perhaps, with a fuel If done in a fiscally neutral manner, carbon tax to encourage emissions reduction in revenues could replace other taxes that may transport (which is not amenable to inclu- be more regressive. In addition, progressive sion in carbon trading systems)—will be “social” tariffs could be introduced where essential to ensure an optimal allocation of price increases in water, electricity, oil, and emissions rights. gas specifically do not affect low-income As a result of these policies, returns to groups. investments in green products and services Second, if carbon trading is introduced, will increase, and “brown” industries will the original allocation of permits, both by be discouraged. More important, the expan- sector and across regions, can be done equita- sion of green industries will contribute to bly with the cost of low carbon transition in economies of scale in production and to mind. Less developed areas may not use their R&D. Competitiveness honed in the domes- full allocation and could potentially earn tic market could accelerate the competi- revenues from the sale of the excess. High- tiveness of Chinese green firms in a rapidly emission enterprises that may be affected by growing international market. Net job cre- carbon emission limits (especially industries ation is likely to be positive. In the long run, that are still subject to price controls or that green development will derive from new cannot pass on the cost of carbon emissions product and process opportunities afforded to consumers) could receive free allocations by innovation aimed at addressing envi- at the beginning, moving to a partial and ronmental concerns, more efficient use of then full auction over time. resources through the removal of price dis- Third, job retraining will be needed for tortions that lead to environmentally harm- displaced workers, as will labor market poli- ful practices, more rigorous appraisal of the cies that permit workers to move jobs and costs and benefits of alternative government locations at relatively low cost. Managing policies and public investments, and lower this transition, and ensuring that the pace economic costs associated with growing of change is well within the capacity of the green now rather than growing now and economy to absorb, will require careful pol- greening later. icy planning and proactive implementation of social safeguards. 46 c h i n a 2030 Chapter 6 Equal Opportunity and Basic Security for All China’s social development over the past in China and gradual ossification of social three decades has been impressive. The coun- structures. In addition, many who escape try has universalized compulsory primary poverty remain near poor, and a shock, such education, expanded participation in higher as an illness, injury, or layoff, could easily levels of education, sharply reduced the thrust them back into poverty (box O.3). burden from infectious diseases, and dramat- Part of China’s income and consump- ically increased health insurance coverage. tion inequality is the result of the “Kuznets Labor has become more mobile, and a grow- effect”—which comes from structural change ing number of rural migrants have moved to as labor moves from low-productivity agricul- cities in search of employment. The “iron rice ture to higher-productivity manufacturing. bowl” social protection system based on state But there are three other drivers of inequal- enterprises has been transformed into a set ity, all related primarily to the inequality of of social protection programs that are being opportunity in accessing social services and expanded and consolidated. social entitlements: Going forward, social policy will need to focus on establishing a welfare system appro- •  China’s decentralized fiscal system and  priate for China in 2030—one that promotes the mismatch at the local government level human capital development, provides basic between resource availability and social social welfare but avoids welfare dependency, spending responsibilities have led to large and creates social conditions supportive of differences in government expenditures growth and development. Its foundation per capita on social services—between should be a basic level of security provided rural and urban areas within provinces, to all, with a particular focus on the poor. and between coastal and interior prov- Just as important, policies should promote inces. The inadequacy of fiscal resources at equality of opportunity in education, health, subprovincial levels also makes many pub- employment, and entrepreneurship to real- lic service units (PSUs) behave like private ize everyone’s full potential and substantially sector prot fi -maximizing units and distorts narrow disparities in income, living condi- incentives for service provision. Spending tions, and wealth that will allow people to differentials have resulted in disparities in enjoy a higher standard of living and share access. For example, progression rates of the fruits of development. rural students to senior secondary school remain far below those of their urban counterparts, and relatively few of them are Key Problems and r isks entering universities. Another example is China’s social policy faces four broad prob- public subsidies on health care, which dif- lems and risks. The first is relatively high fer by several multiples between urban and inequality, some dimensions of which may rural residents. Just as important, spending have even worsened in recent years. Inequality differentials have resulted in “inequality of remains high in incomes, consumption, and quality” in education and health services asset ownership, as well as in access to qual- and in the degree of financial protection ity education, health, jobs, and social protec- offered by pension and health insurance tion programs across and within regions and programs. Such disparities in turn lead to especially between rural and urban areas. inequality in job opportunities, productiv- Although regional inequality appears to have ity, and eventually incomes, as well as in narrowed to some extent, other dimensions of risk management capacities. inequality, such as housing wealth (account- •  Institutional arrangements and policies  ing for some 60 percent of total household reinforce and, in some cases, accentuate wealth), have increased. Rising inequalities inequalities; examples include the differ- increase the risk of reduced vertical mobility ent rural and urban social entitlements over vie w 47 BOX O.3 r educing poverty for agricultural investments can improve the con- Over the past three decades, more than 500 million ditions of poor rural residents and migrants, while Chinese have moved out of the ranks of the poor— also improving opportunities in agriculture through an achievement of historical significance. At the additional investments in rural infrastructure (nota- same time, China still has a large number of poor bly water, renewable energy, and roads). people—204 million in 2005 when applying a $1.25 Fourth, returns to labor can be raised by relaxing a day poverty line (purchasing power parity) and disincentives to rural-urban migration and providing household consumption as the measure (Ravallion migrants affordable access to urban services through and Chen 2008). Reaching those that still remain the phased reform of the hukou system. These steps below this international poverty line will prove dif- would not only raise household incomes of the poor ficult. Many are in remote western provinces, and and reduce poverty and inequality, they would also the rest are dispersed throughout the country. Many boost household consumption, and at the same more are “near poor”—just above the poverty line time allow firms more time to make the adjustment and only one crisis away from falling back into pov- from labor-intensive to skill-intensive production. erty. The challenge facing the country will therefore Complementary efforts could include improving the increasingly be to reduce risks faced by the near- education and skill base of potential migrants before poor and tackle transient poverty. The recommenda- they migrate, providing assistance to migrants to tions below are designed to meet this challenge. reduce job search and information costs, increas- First and foremost is the need for continued rapid ing connectivity between rural and urban areas, growth. Throughout the world, higher growth has and improving the investment climate in the poorest meant greater likelihood that incomes and con- western provinces where the bulk of poor potential sumption rise above the poverty line for increasing migrants reside. numbers of people. But poverty is not just about Fifth, notwithstanding significant improvement income—it is also about access to affordable qual- in recent years, social protection instruments— ity health care and education and the ability to health, unemployment, and pension insurance— deal with risks. Indeed, China’s rising inequality is need to be strengthened to meet two objectives: largely the result of inequality of opportunity; one’s insuring the poor against a variety of risks with connections, place of birth, employer, and parental adequate but sustainable financial protection; and circumstances still play a large role in gaining access making full portability of entitlements a reality to to critical social services. promote occupational and geographical flexibility Second, it follows that identifying the poor for workers, giving them the freedom to seek better and vulnerable through a metric broader than just and more productive jobs wherever they may be. income—one that includes access to public services Finally, because local governments shoulder the and ability to deal with uninsured risks—will help bulk of the responsibility for implementing and targeted poverty reduction programs and keep pov- financing these programs, they cannot be expanded erty reduction at the top of the government’s devel- without fiscal reforms (identified in chapter 7). opment agenda. China has developed a household- Bridging the gap between expenditure responsibili- based targeting system for providing direct assistance ties and revenue sources is one priority, and reducing to the poor, but there seems to be scope to improve regional disparities in fiscal performance is another. this program through a more explicit proxy-means This in turn warrants strengthening the fiscal system targeting system based on easily observed household so it can shoulder these additional responsibilities. characteristics that are correlated with income. Third, universal access to quality health care, sec- ondary and higher education services, and finance created by the hukou system, and the migration from rural areas to cities, from fragmented institutional arrangements interior to coastal provinces, or even from and delivery systems that limit portability city to city, because most migrants are of entitlements and impede labor mobil- denied access to affordable health, edu- ity. Thus, notwithstanding recent local cation, housing, and pension coverage to hukou reforms, there remain obstacles to which urban residents have access by right. 48 c h i n a 2030 •  Other factors also contribute. For exam- and poses future challenges for social policy ple, high taxes on labor—to pay for social formulation and the economy more broadly. insurance—limit formal sector employ- With rising life expectancy and with total ment opportunities, lower remuneration fertility at only around 1.5, the country for workers, and bias investment toward is “growing old before growing rich.” As capital-intensive technologies. In addition, the country ages, the labor force will peak weak labor market institutions, in particu- around 2015 and then start to shrink (albeit lar the wage determination system, do not gradually at first), and health and pension provide an effective platform for balanc- costs will escalate. A smaller workforce, ing the interests of workers, employers, combined with higher dependency rates, puts and sustained competitiveness to ensure a premium on deepening human capital to the growth of labor earnings in line with enhance labor productivity, places additional increasing profits. The labor market is demands on education and training systems segmented between and within localities, to increase relevant skills, and heightens the often according to the hukou, income, and importance of ensuring that labor is allo- social status of workers. As a result, work- cated efficiently. Moreover, the aging of the ers without family or social connections population means that the disease profile has are disadvantaged in accessing government changed sharply toward noncommunicable or public enterprise jobs. The lack of porta- diseases—a trend that will only accelerate— bility of social entitlements and differences requiring a shift in health care strategy from in worker wage and entitlement terms curative to preventive care and better health between the formal and informal sectors, education for children and adults. The fis- and between the private and public sectors cal costs of health and pension programs (state enterprises, PSUs, and government will need to be contained through greater departments) exacerbate the segmentation. emphasis on primary care rather than hospi- tals, structural reforms in pension systems, A second challenge is inefficiencies in efficiency improvements in service delivery social service delivery stemming from dis- driven by information and communications torted incentives and market structures. technology (ICT), and better incentives for Public organizations and agencies exercise health care providers. a monopoly or quasi-monopoly in delivering And the fourth challenge is rising expec- social services and face little competitive pres- tations, especially among second-generation sure to improve efc fi iency or quality. Pressure migrants and a rapidly growing middle class, from users of services is also limited because for higher wages, greater income security, government incentive structures are not based better social services and greater equality in on downward accountability. As noted, the access, and a voice in the design and deliv- revenue and incentive structure in health ery of those social services. There is grow- and, to some extent, education services ing dissatisfaction with service providers and encourages public providers to maximize increasing expectations for more accountable, revenues and to act as profit-maximizing affordable, and equitable social programs. private sector entities. This results in some The expectations and interests of different undesirable outcomes: for example, between groups may not be aligned, however, and may a third and a half of admissions to hospitals even conflict with one another, raising con - in China are estimated to be unnecessary; the cerns that unless these deep inequalities are average number of days in hospital is double reduced, social unrest could grow. the OECD average (World Bank 2010); and school selection fees in urban areas drive a Proposed r eforms further funding wedge between “key” schools and regular schools, excluding many deserv- Based on these problems and challenges, ing students. social policy reform has three objectives. The third challenge is rapid aging of the The first is to reverse rising inequalities in population. China’s demographic transi- income, consumption, and access to public tion will be among the most rapid ever seen services and ultimately to ensure that equal over vie w 49 opportunities are available to all, irrespec- rely on competition with appropriate regula- tive of whether someone is migrant or local, tion; and accountability to citizens for qual- old or young, in the city or countryside, or ity services by increasing the role of civil soci- from the coast or interior. The second is to ety organizations in monitoring and in some help households better manage employment, cases giving them co-responsibility for man- health, and age-related risks, and ensure a aging social services. Emerging local experi- basic level of security. The third is to promote ence in China with citizen participation in greater accountability of service providers, oversight and management of service delivery public and private, to ensure that services are (for example, through school councils, elec- made available in the right amount, at the tion of school principals, and medical dispute right place, and of the right quality. mediation councils), and in providing feed- To achieve equality of opportunity for back on service quality (for example, through all by 2030, the policy focus will require web-based public feedback and citizen score expanding opportunities to include all citi- cards) suggests that China can benefit from zens so they can access quality, affordable more active citizen participation in service health and education services and share in, as delivery as many other countries have. well as contribute to, the country’s prosperity To achieve these objectives, China needs through equal participation in the labor mar- to develop a vision, core values, and guiding ket. To become a competitive high-income principles for social policy reforms. Policy economy, China must deepen and broaden makers need to ask two questions: What level its human capital base and put it to the most of social services and protection should the productive use. state aim to finance, and how much of the A more complex and dynamic economy burden should be shouldered by individu- also brings greater risks for workers during als and households? And what should be the and after their working lives, and reducing roles in service provision of government, the these risks requires measures that enhance private sector, and communities? In China, security in old age and help workers bet- the answer to the first question will depend ter manage risks inherent in a more flexible on the amount of fiscal resources the gov- labor market. The provision of such “flexi - ernment intends to devote for this purpose. curity” requires making structural reforms Extending the current level of urban ser- in pension and unemployment insurance vices and social protection to rural residents systems so that workers have reasonable and and migrants—well over half the popula- portable support in old age or when unem- tion—will itself impose a significant burden ployed, while avoiding an ever-increasing on fiscal resources. Therefore, additional burden on the working population; ensur- government-financed social services should ing comprehensive coverage of pension be undertaken with considerable caution and insurance, in particular for rural citizens, only if they do not strain the fiscal system (see migrants, and informal sector workers in chapter 7). At the same time, international urban areas; preparing for and gradually experience suggests that social spending expanding long-term care for the aged and accounts for the bulk of incremental public terminally ill; and strengthening labor mar- expenditure as countries get wealthier. China ket institutions to enable wage bargaining will want to strike the appropriate balance and dispute settlement mechanisms that bal- and avoid the current predicament that many ance the interests of workers and employers. advanced countries face—a fiscal crisis that Underpinning these reforms is the cross- has arisen, in part, from financially unsus - cutting need to promote greater accountabil- tainable entitlement programs. ity for results in social services and social pro- tection programs. Accountability would need Achieving Equality of Opportunity to come through three channels: administra- tive systems that monitor performance and Providing equal access to quality, afford- encourage quality and equity in service deliv- able education and health care for all by ery; market-based mechanisms that encour- 2030 requires action in several areas. In the age the private delivery of public services and first place, the challenge will be to continue 50 c h i n a 2030 fiscal and structural reforms that ensure the role for communities and the nongovernmen- wider framework for equitable and sustain- tal sector, often with financial support from able service delivery. But these will need to the state. The experience of OECD countries be accompanied by sectoral reforms that pro- suggests a range of innovations in unbun- mote opportunities to build human capital dling financing, provision, and regulation of and allow people to be healthy and produc- social services that China could consider. At tive across the life cycle. the same time, achieving plurality of social Based on a vision of China’s future social service provision while ensuring quality will policy, the government will need to put in require the state to assume a greater role in place the appropriate fiscal measures— licensing, accreditation, oversight, and regu- increased aggregate social public spending lation of providers. commensurate with the level of development, Third, integration of ICT in social service lower payroll taxes to increase labor intensity and social protection delivery systems should in production and encourage formal sector be increased. This integration could include employment, and stronger fiscal equalization electronic medical records, telemedicine, dis- across local governments at the subprovincial tance learning, and high-functionality smart level (see chapter 7). cards that allow individuals easy access to In addition to fiscal measures, several their key medical data from anywhere. A structural reforms in the social sectors can good ICT system will permit exchange of improve the efficiency of service delivery and data and financial information across the help achieve equality of quality. First, human country, dramatically reducing administra- resource management should be reformed tive costs and costs to the population. But for service providers, through effective moni- realizing such gains requires harmonization toring of performance on key outcomes, of data standards and systems to end the cur- strengthening the link between provider per- rent situation of major investments by local formance and career progression, providing authorities in IT systems that are incompat- incentives that discourage rent-seeking, and ible with one another. ensuring that the best health providers and Fourth, intra- and intersectoral coordina- teachers also provide services to underprivi- tion is needed for policy development and leged urban and rural areas (for example, delivery of social services. As economies through rotation policies for teachers and age and grow richer, effective social services outreach programs for hospital doctors to increasingly require better cross-sectoral periodically provide services to poor patients). coordination. For example, within health Second, nonstate provision of social ser- services, coordination of care across levels vices should be increased, and different of service is critical for managing noncom- stakeholders (communities, commercial and municable diseases, and for education, the nonprofit providers, and even households boundary between technical and vocational themselves) given greater co-responsibility. education and training and academic streams The state cannot and probably should not becomes more porous. Across sectors, new “do it all” as it seeks to provide a wider and needs such as long-term care require inputs deeper range of social services and social from social welfare, health, and other agen- protection programs. Involving the nonstate cies, while labor policy for older workers sector will open up new possibilities, from requires coordination of social security and private hospitals and clinics, to private pre- training initiatives. Developing an adminis- schools and universities, to involvement of trative system of cross-sectoral coordination private insurers and third-party administra- requires the transformation of government tors. In some fields, such diversification may functions and responsibilities. also benefit from enhanced partnerships These structural reforms need to be with international firms. New approaches to complemented by a range of sector-specific financing will also be required. Greater plu - policies to promote equality of quality from rality of service provision also offers a greater young children to the elderly. over vie w 51 FIg Ur E O.6 Unequal spending on early childhood development Education. A key priority in improving across Chinese provinces equality of quality will need to be an equal start in life for all children, especially in the 14,000 areas of early childhood nutrition and educa- tion for rural and poor children. These are 12,000 some of the highest return social investments in the next generation. The government 10,000 should prioritize nutritional supplements for 8,000 children ages zero to three and for pregnant or lactating women in all poor rural coun- 6,000 ties, especially in the central and western provinces, and for migrant children in urban 4,000 areas. The cost of such a program is not prohibitive—this intervention is in fact very 2,000 cost-effective in light of the high returns to health, cognitive development, and produc- 0 0 20,000 40,000 60,000 80,000 tivity. Over time, the focus of child nutrition efforts would increasingly need to shift to GDP per capita stemming the incidence of childhood obesity, ECDE total ECDE budgetary which is already approaching Western levels in a number of China’s coastal cities. Source: World Bank staff estimates based on data from Chinese authorities. Note: ECDE = early childhood development and education. Similarly, early childhood education for three- to six-year-olds is another relatively low-cost, high-return public investment. In by 2020—comparable to Korea’s senior high the coming five to ten years, the program enrollment rate in 2000. Following the exam- should focus on children in poor rural coun- ple of the abolition of fees for compulsory ties, gradually expanding to rural areas in (primary and junior secondary) education, a central and western provinces, and migrant similar policy is needed for senior secondary children in urban areas (figure O.6). The schools in rural areas, together with a paral- financing can come through supply-side sub - lel initiative for poor and migrant children in sidies to providers and fee exemptions for tar- urban areas. This could be financed in part geted households. Another option could be by the incremental public funding that China the use of conditional cash transfers (CCTs) has already committed in its Education Law targeted to poor households. CCTs have (4 percent of GDP, around half a percentage proven to be effective in other developing point above current levels). countries, and pilots in China indicate that they have significant potential. Health. Just as in education, much needs to Another priority will be extending afford- be done in health. Deepening health reform able access to secondary education. High fees is one of China’s biggest social challenges in are a key reason why a significant portion of the coming years. At the same time, Chinese rural children fails to enter senior second- and international experience demonstrates ary schools (fees are high because schools that health sector reform is one of the most are encouraged to use them to make up for complex and politically challenging reforms inadequate financing through local govern - that governments confront, a challenge exac- ment budgets). Yet, given the needs of the erbated in China by the rapid pace of popula- Chinese economy over the next two decades, tion aging and the explosion of noncommuni- and given the experience of countries that cable diseases, which, in 2009, accounted for have moved from middle to higher income, more than 80 percent of all deaths in China providing free senior secondary level educa- and 82 percent of the total disease burden. tion will be essential. China has set itself a 90 A critical challenge is reorienting China’s percent senior secondary enrollment target three-tier health delivery system away from Expenditure per student (RMB) 52 c h i n a 2030 the current hospital-centric model to one promote administrative efficiency, and facili - that manages care across levels of the system tate portability of entitlements. Greater pool- with a revitalized primary health care system ing would also pave the way for greater inte- playing the key role in care coordination. Pri- gration of schemes across rural and urban mary health care, in turn, will need to have areas. In this process, health insurance agen- stronger links to the broader health delivery cies could gradually ensure value and qual- system to manage the epidemic of noncom- ity of health services, including through con- municable diseases and to control the escala- tracts with public and private providers. More tion of health service costs. Up to 85 percent broadly, the experience with the New Coop- of patients with noncommunicable diseases erative Medical Scheme and urban residents’ need primary care because their conditions health insurance schemes points to the need are best controlled with self-management. to consider over time an appropriate balance This care can—and should—be provided and between financing from health insurance con - managed by a strong primary health care sys- tributions and from the budget. Developments tem that is well-coordinated with the broader in the rest of Asia point to an increasing role health care system. Greater reliance on pri- for general revenues in financing health care, mary health care will mean less demand for especially for the poor. hospital-based care, which has been a key In parallel, provider payment reform must factor behind the major cost escalation expe- be accelerated to increase the incentives for rienced in the Chinese health system in recent all health providers to produce efficiency and years. Unnecessary admissions and over- quality. A number of efforts have been made treatment have made hospital costs in China to control costs in the health system, includ- a significant outlier compared to a range of ing drug lists, zero markup policies, and con- OECD countries. trols on the use of costly medical equipment The necessary reorientation to primary and procedures. But without a more funda- and preventive care in China will be diffi- mental shift away from the current provider cult to achieve without further progress on payment systems, the basic provider incentive hospital reform. Fundamentally, it will be structure will continue to drive inefficiencies necessary to change the current incentives and inappropriate care. Changes in incentives for public hospitals and doctors to behave will need to be complemented with a stronger like private providers. The key reform will emphasis on professional ethics among pro- be setting firm budget constraints on public viders and tools for greater accountability of hospitals through a more active purchas- providers to patients. ing role for health insurance agencies and Going beyond the health system, China’s the use of information to monitor and pro- aging population will increasingly require vide better incentives for improved provider aged and long-term care (ALTC), as the 4-2-1 performance. Evaluating the experience in extended family structure places greater care improving hospital governance and manage- burdens on adult children. To date, the policy ment will also be important. Given the diver- framework for ALTC is limited, and its mul- sity in hospital organizational reforms across tisectoral nature has posed institutional chal- China, it is necessary in the short run to have lenges to developing a coherent approach. more rigorous evaluation of different models Nor are there enough appropriately trained and the lessons from them. personnel to provide required services. Given Reforms of the health delivery system will the early stage of development of ALTC in be effective, however, only with a broader China, a first need is deciding on the appro - reform of the incentive structure for health priate mixture of public and private financing care providers, including health financing and and provision and the role of the public sector provider payment arrangements in particu- for different population groups. These deci- lar. An initial step will be to raise the pool- sions would benefit from extensive piloting ing level of the health insurance system to and local experimentation. Another key issue harmonize benet fi s across different schemes, will be the institutional and coordination over vie w 53 arrangements for the ALTC sector, given system. Since the 1990s, China has put in the number of public and private actors place a comprehensive package of social involved. Once these questions are decided, a protection programs at a speed that is framework for ALTC can be developed that unprecedented internationally. These include involves mixed models of providers (state, pension programs for urban and rural resi- nonstate, communities, and households) and dents; pension, unemployment, sickness, ensures that basic standards of care are met. workplace injury, and maternity insurance for urban sector workers; and a national social assistance scheme that now covers Achieving Flexicurity more than 70 million people, among others. An increasingly open economy with greater But there remains a big unfinished agenda to labor market flexibility brings greater risks deepen the reforms already introduced. for workers during and after their work- The first item on this agenda is the need ing lives. To help them manage these risks to expand coverage of the pension system requires flexicurity—labor market and social among rural residents, migrants, and other security institutions that promote flexible urban informal sector workers. Until very and efficient allocation of workers and also recently, China had pension coverage well ensure they have decent working conditions below that expected of a country with its and adequate social protection during and per capita income (figure O.7). Low cover - after their working lives. age has been driven by the absence (until very A first element of flexicurity is a set of recently) of a national rural pension program, labor market policies and institutions that the very low participation rates of migrant promote an internationally competitive workers in urban schemes, and the absence workforce in which workers share in the ben- until mid-2011 of a pension scheme for urban efits of growth and also enjoy some social informal sector workers (30– 40 percent of protection. This would first require eliminat - the urban labor force). Current policies com- ing the remaining barriers to labor mobil- mit to comprehensive coverage of the pen- ity—the most critical measure being phased sion system by 2020, and new schemes for reform of the hukou system (see chapter 3). rural workers and urban residents represent a To improve labor mobility, segmentation major step in this direction. To achieve com- among social protection programs needs to prehensive coverage, the authorities could be reduced to promote an integrated and consider a system with three pillars: a basic seamless social security system. Social secu- benet p fi illar that provides minimum poverty rity entitlements should be portable within protection to the elderly through noncon- and across provinces, and with central gov- tributory social pension benefits (this would ernment involvement reducing interprovin- build on the general approach being taken in cial disparities in social insurance protection. the new rural and urban residents’ pension In parallel, labor market institutions will be schemes); a contributory pillar with a man- needed to support wage determination that datory notional defined contribution scheme is driven less by administrative direction for workers with wage incomes (modifying and more by collective bargaining where the the current urban pension system) and a vol- interests of workers and employers are bal- untary defined contribution pension savings anced. Finally, by 2030, as people live longer scheme for urban and rural residents with and healthier lives, the retirement age will nonwage incomes; and a supplementary sav- need to rise gradually. Flexible work arrange- ings pillar for the urban and rural popula- ments could make continued work more tion providing voluntary occupational and attractive, and life-long learning opportuni- personal pensions that may supplement other ties for workers would help reduce the deple- pension benefits. tion of human capital with age. The second priority is the need to ensure The second element of flexicurity is a the fiscal and financial sustainability of exist - robust but sustainable social protection ing urban pension systems in order to ensure 54 c h i n a 2030 FIg Ur E O.7 Pension coverage rate of the active labor force, pension contribution rates to enhance the various countries, mid-2000s competitiveness of Chinese workers. Finally, voluntary supplementary saving arrange- ments will need to be expanded for those workers wanting pension replacement rates above the basic level. 80 The third priority is the reduction of frag- mentation across different subsystems of the pension system. The integration agenda has both a spatial dimension and a cross- program dimension. Across space, greater China portability in the short run would be com- plemented by pooling funds at higher levels 0 over time, first at the provincial level and 0 10,000 20,000 30,000 40,000 50,000 60,000 ultimately at the national level. Across pro- Income per capita (PPP) grams, within the urban schemes, PSU and civil servant schemes should be gradually Source: Holzmann, Robalino, and Takayama 2009. merged with the urban workers’ scheme in Note: PPP = purchasing power parity. line with emerging global practice. In addi- tion, national policy can build on the grow- a credible commitment to basic security in ing provincial practice of merging rural and old age. Pension reform will need a robust urban residents’ schemes so that mobile financing strategy that ensures basic benet fi s workers have a more harmonized and ulti- consistent with fiscal constraints. A key step mately integrated system as they follow pro- is phased increases in the retirement age in ductive work opportunities. line with higher life expectancy, and gradu- Finally, there is a broader need to build ally harmonized retirement ages for men a more coherent social protection system, and women. In addition, there is a need to where the individual elements are aligned and address the issue of inadequate returns on the system is more than the sum of its parts. contributions in the current urban system, The Chinese government has committed to while controlling investment risks (for exam- guaranteeing the poor a decent living with ple, through a notional defined contribution access to public services, including education, approach). Pension reform will also require health, and housing by 2020, and the social a strategy for financing the legacy costs of protection system will play an important the urban system. Pension liabilities for those role in this process by assuring a minimum under the previous pension regime—so-called standard of welfare for the poor (State Coun- legacy costs—are estimated to range from 82 cil 2011). In addition, the medium- to long- to 130 percent of 2008 GDP, depending on term agenda in social protection will require assumptions. An appealing option for financ - greater coherence across insurance, social ing this obligation would be to gradually pay assistance, and other welfare and antipoverty it down through incremental fiscal resources, programs to ensure not only that the poor are while all the time ensuring that assets accu- protected but also that the near-poor are not mulating in pension funds are properly man- subject to “poverty traps,” where low-wage aged and yield rates of return adequate to earners are worse off than those receiving meet future liabilities. This approach in turn social assistance. would create space for future reduction in % of labor force over vie w 55 Chapter 7 Strengthening the Fiscal System and Aligning It with the Evolving r ole of g overnment Over the past two decades, China has fiscal space. Finally, although the share of reformed its fiscal system significantly. A public expenditures on social and environ- major overhaul in 1994 focused on enhanc- mental services has climbed in recent years, ing revenue mobilization and revamping the large social and environmental agenda national-provincial fiscal relations. A new over the next two decades will entail further tax system with a value added tax at its core increases in public spending. laid the foundations for a significant increase At the same time, it is important that in the ratio of revenue to GDP. The reforms China preserve fiscal stability to protect also launched important changes in China’s against future macroeconomic shocks. The system of intergovernmental fiscal relations. demand for additional budgetary resources Changes in tax assignments increased central to address social and environmental needs government revenues, laying the foundation will arise at a time when China’s total public for larger and more rules-based transfers to spending is already high relative to GDP, and subnational governments to help tackle fis - the emergence of structural budget deficits cal disparities. The combination of these could potentially erode available fiscal space reforms put public finances on a solid foot - and pose a risk for future fiscal stability. So ing, allowed China’s government spending to the challenge China faces is to contain the grow to levels comparable with other econo- level of government expenditures as a share mies with similar incomes, and paved the of GDP while at the same time changing the way for increased social and environmental composition of those expenditures to address expenditures. evolving strategic priorities. This will require fiscal discipline as well as budgetary proce - dures that allow reallocation of resources Key Fiscal Challenges over time from lower- to higher-priority gov- Now a key challenge is to further strengthen ernment programs. How China deals with China’s fiscal system, improve fiscal sustain - two key factors—its decentralized fiscal sys - ability, and align it with the evolving role tem, and its public finance management sys - of government to support the delivery of a tem—will be central to achieving these objec- large economic, social, and environmental tives. Consider each in turn. agenda by 2030. For example, in the eco- China is among the most decentralized nomic sphere, improvements in the efficiency countries in the world when it comes to gov- and independence of the financial system ernment expenditures, but government rev- will mean that some of its quasi-fiscal func - enues are highly centralized. Its subnational tions will need to be transferred gradually governments account for around 80 percent to the fiscal system. Additionally, as state of total budgetary expenditures and bear enterprises are subjected to hard resource responsibility for the provision of vital public constraints and better credit evaluation cri- services including basic health and education, teria, their restructuring, closure, or owner- pensions, unemployment insurance, disabil- ship diversification may require budgetary ity, housing, infrastructure maintenance, and support. A strong fiscal system will also be minimum income support. But local govern- central to China’s objectives to meet domes- ment revenues—available through the tax tic and external economic shocks as and revenue-sharing mechanism and intergov- when they arise—the 2009–10 fiscal stimu - ernmental fiscal transfers—are not commen - lus package being an example of what can surate with local government expenditure be achieved when an economy has adequate responsibilities. On average, these “revenues” 56 c h i n a 2030 from the center finance 40–50 percent of the bulk of government expenditures, includ- expenditure burden of local governments. ing center-provincial revenue sharing and Moreover, provincial governments have con- resource transfers), the government-funded siderable discretion in transferring resources budget (comprising off-budget revenues to subprovincial governments, and it is at and expenditures), the state capital budget the local level in poorer jurisdictions that the (financed by dividend payments from state imbalance is most acute between available enterprises), and the social security fund resources and responsibility for public service budget. The absence of a comprehensive bud- delivery. get makes it difficult to assess or alter the While intergovernmental transfers are aggregate allocation of government resources common in most large countries, China is across priority sectors and programs. Min- unusual in the discretionary power wielded istries have substantial latitude in allocat- by provincial governments and the fiscal ing earmarked transfers to the provinces. stress experienced at the lowest level of local Few budget details are made available, and government responsible for service delivery. there is little oversight by higher authorities In pursuit of rapid growth and motivated to or discussion about implicit intra- or cross- “collect resources to do big projects,” subna- sectoral priorities. Moreover, little informa- tional governments have identified innova - tion is available on whether governments tive ways to raise resources locally. China’s spend money according to budgetary alloca- subnational governments derive substan- tions (except at the broadest levels), whether tial revenues from fees of various kinds, the government expenditures and programs lead sale of land use rights, and taxes on real to the desired outputs, and whether the out- estate transactions. Distorted incentives to puts lead to the expected outcomes. Internal develop land can lead to corruption, forced audits focus on detecting malfeasance, not land acquisition, inefficient use of land, and program performance. Additionally, the bud- abuse of government power. Because local get cycle and the expenditure cycle are not governments are prohibited from borrowing synchronized. Thus, even though the fiscal directly from banks, they have established year starts at the beginning of the calendar special purpose vehicles that are free to bor- year, the budget is not finalized until the end row for infrastructure and urban construc- of the first quarter of the calendar year. This tion, financed principally by local land sales delay forces government departments to start and bank loans, often with land as collateral. program implementation before budgetary Such activities have contributed to systemic authorization. While that may seem a small risks in the financial sector (see chapter 3). procedural matter, it tends to reinforce the Arguably, the availability of revenue and view that the budget itself is a formality with borrowing outside the general budget has little operational significance for local gov - fostered some degree of local government ernments and central ministries. independence (especially because most trans- fers from higher levels of government are for Proposed r eforms earmarked expenditures). But not only have locally generated revenues led to distortions Over the next two decades, then, China’s in land and financial markets, they may also challenge is to reform its fiscal system in the have exacerbated inequalities. Some poor following four ways: first, to contain gov- provinces, townships, and villages may not ernment expenditures as a share of GDP be able to raise enough resources locally to but change their composition in line with provide quality services, and poor house- China’s new challenges, with higher alloca- holds cannot afford their high cost (see tions for social and environmental public chapter 6). investment and recurrent expenditures; sec- Finally, government financial manage- ond, to improve the efficiency of revenue ment, fiscal transparency, and accountabil - mobilization, including through changes in ity are key issues. China currently runs four the structure of revenues; third, to reform budgets—the general budget (comprising the intergovernmental fiscal relations, including over vie w 57 through better alignment between resource these incremental expenditures could be met availability and expenditure responsibility at through efficiency improvements in current different levels of government; and, fourth, expenditure programs and the rest through to strengthen the management of government reallocation away from lower-priority invest- finances and improve the efficiency of public ment budgets (such as infrastructure). expenditures. Managing such a fundamental shift in government expenditure composition by 2030 while containing its total share in GDP Containing g rowth of g overnment will prove to be a major challenge. China’s Expenditures While Altering Their total government budget and off-budget Composition expenditures as a share of GDP are about The composition of government spending the same as some other upper-middle- and will need to evolve to reflect China’s chang - high-income countries. It would be inappro- ing development challenges. Most notably, priate to push it higher. At no point should the next 20 years will see a pressing need to China fall into the “high-income trap” by further increase spending on health, social expanding entitlements to the point that they protection, and environmental protection. become fiscally unsustainable in the long run. These increases will be important to provide To prevent such an occurrence, a debt and social security and a basic set of public ser- fiscal sustainability analysis that accounts for vices and to build human capital and expand contingent liabilities and considers alternative opportunity (see chapters 5 and 6). stress tests should be required as a condition The amount of public spending relative to for the approval of each annual budget. GDP for social and environmental protection will depend on choices the authorities make Improving the Efficiency of r evenue in the current and upcoming five year plans. Mobilization While China’s reported spending on environ- mental protection appears to be in line with Since the 1994 fiscal reforms and subsequent OECD and upper-middle-income country improvements, China has been very success- standards, the significant backlog and new ful in mobilizing revenues. But it has sig- challenges in this area could well require a nificant untapped potential to increase the further scaling up of such expenditures over efficiency of its tax structure. These are con- the next two decades. In health, however, the centrated in six areas. scaling up of China’s public expenditures will First, higher taxes on energy (carbon), need to be significant. If high-income coun - water, natural resources, and pollution tries are used as benchmarks, the share of will encourage resource conservation while public spending on health in GDP can range improving environmental outcomes and gen- from 4 percent (in Switzerland) to near 8 per- erating revenues (see chapter 5). Second, cent (in Iceland). China’s current spending is raising SOE dividend payments to the general about 2.5 percent of GDP. budget (perhaps through the intermediary Using these and other international bench- structure of state asset management compa- marks as reference, China could potentially nies; see chapter 3) will spur more efficient aim to increase public expenditures by 1–1.5 investment planning in SOEs while also gen- percentage points of GDP for education, 2–3 erating significant budgetary resources. percentage points for health care, and another Third, additional revenues can potentially be 3– 4 percentage points to fully finance the mobilized from personal income taxes. These basic pension pillar and to gradually meet the taxes make up only 1 percent of China’s legacy costs of existing pension obligations. GDP, compared with an average of 5.85 per- These add up to an incremental fiscal outlay cent in high-income countries. of around 7–8 percent of GDP, a reasonable Fourth, enhanced taxation of motor vehi- estimate to bring China’s aggregate “social cles and parking (as a near-term option) and expenditures” by 2030 to near the lower end congestion pricing (as a longer-term option) of the range of high-income countries. Part of would lead to more efc fi ient and livable cities 58 c h i n a 2030 FIg Ur E O.8 Local governments: Large and better environmental outcomes. Fifth, expenditure responsibilities, inadequate revenues property taxes will encourage more effi- cient use of land while also reducing urban sprawl and lowering local government depen- dence on funds from land acquisition. While promising, property taxes are unlikely to be- come a major source of overall revenues for some time; very few developing countries raise more than 1 percent of GDP from this source (Bahl 2009). Sixth and finally, the gov - ernment could capture important economic rents by auctioning public resources such as bandwidth user rights, franchises for public 1978 1990 1995 2000 2005 2008 utilities, and exploitation rights for natural Ratio of local government spending to resources. Not only will such measures raise total government spending government revenues, they would prevent Ratio of local government revenue to politically powerful interests from capturing total government revenue these economic rents for free. Source: NBSC, various years. Make r esource Availability Commensurate with Expenditure to be implemented in a manner consistent r esponsibility at All Levels of with ongoing discussions regarding reforms g overnment in the number, structure, and hierarchy of Local governments are responsible for 80 subnational governments. In addition, it percent of government expenditure respon- may be appropriate to selectively raise some sibilities but receive only slightly more than expenditure responsibilities to higher levels 40 percent of tax revenues (in the form of of government or to pool their financing at transfers from the central government) (fig - these higher levels. Scope for such reforms ure O.8). The recentralization of revenues in lies largely, but not exclusively, in health and 1994 strengthened the central government’s pension spending (see chapter 6). Ultimately, capacity to redistribute in favor of poorer any such solutions will need to be guided by provinces. The most serious disparities in a clear understanding of the functions and resource availability, however, occur at the responsibilities of subnational governments subprovincial level, which was not included in China. in tax-sharing arrangements in 1994 and Subnational governments will be able which is responsible for more than 50 per- to increase their fiscal autonomy if they are cent of total public spending. Fiscal transfers given increased scope to raise their own rev- to subprovincial levels remain largely at the enues. The high disparity in development discretion of powerful provincial govern- across different countries, townships, and ments and are subject to negotiation, leading villages warrants some flexibility in revenue to high disparities across subprovincial local assignment. China could consider first grant - governments. ing new sources of “own” revenues—such One way to deal with the disparity in as property taxes and capital gains taxes on government resource availability across and agricultural land acquired for urban develop- within provinces would be to introduce ment (see chapter 3)—to subnational govern- rules governing resource transfers from the ments in relatively developed cities to replace provincial to the township and municipal- revenues from land acquisition. This step ity level. Increasing the autonomy and capa- would free up fiscal resources at the center bilities of local governments is a common for additional transfers to poorer regions trend in other countries, even in unitary and help bring a larger share of subnational states. But in China, such increases will have financing on budget. In addition, citizens are Percent over vie w 59 likely to hold officials more accountable if of government in a manner consistent with local public services are financed to a signifi - reforms, also under way, to the structure cant extent from locally imposed taxes. of subnational governments. This step is Increasing the fiscal autonomy of local a key toward streamlining the size of gov- governments can be supplemented by allow- ernment, improving the efficiency of gov - ing them to prudently expand on-budget bor- ernment services, and empowering county rowing. In the past, local governments have governments. circumvented the rule against borrowing by •  Third, to discipline the budgetary process,  establishing Urban Development Investment the budget and expenditure cycles need to Corporations and other special purpose vehi- be synchronized by either finalizing the cles that can borrow using land as collateral. budget two months before the start of the Total local government debt in 2010 reached fiscal year or moving the start of the fiscal as high as 26 percent of GDP, according year to April 1. to the National Audit Office. Such indi- •  Fourth, independent agencies should be  rect borrowing played a significant role in used to conduct rigorous performance eval- financing infrastructure investment and uations of government programs on a ran- thus supported rapid industrialization and dom basis. These evaluations will help pro- urbanization. But lack of transparency and vide feedback on the allocation of resources regulation has created potential risks to fiscal and identify programs that are delivering sustainability, and such quasi-fiscal financ - the right outcomes and those that are not. ing also obscures the true size and composi- •  Fifth, treasury management and budget  tion of public spending and revenues. China accounts, together with cash management, has recently introduced a pilot program that could be strengthened to streamline dis- allows selected local governments to issue bursements, introduce fiduciary controls, bonds. There is a pressing need to revise the and prevent fraud and corruption. Budget Law and establish the institutions for •  Sixth, a strict tally could be kept of contin- bond issuance by local governments. Over gent liabilities accumulating in the banking time, subnational governments should be sector, state enterprises, and local govern- allowed to borrow from the domestic capital ments and conduct regular fiscal sustain - market on the strength of their own credit- ability analyses, accounting for these liabil- worthiness but subject to a prudential regula- ities under different stress scenarios. tory and institutional framework for subna- •  Seventh, all levels of government should  tional debt. complete the process of bringing all pub- lic revenues and expenditures on budget in accordance with the latest Ministry of Improve g overnment Financial Finance regulations. Management •  Eighth, the central government should  China could introduce a number of public change the criteria for performance evalu- finance management reforms to improve the ation of local officials from an emphasis efficiency and effectiveness of public finances, on growth to a focus on a “harmonious but here we just mention nine possibilities. society.” •  Ninth, and perhaps most important, all  •  First, it could bring all off-budget govern- levels of government should publish and ment revenues and expenditures on bud- make transparent all budgetary revenues get and prepare a comprehensive budget and expenditures from aggregate sectoral that combines the general budget, the allocations and outturns to project level government-funded budget, and the state allocations and outturns. In the experience capital operating budget, and includes cur- of other countries, this disclosure has been rent and capital expenditures together with one of the most powerful ways to improve transfers. expenditure efficiency and ensure that bud - •  Second, China could complete the ongoing  getary resources are used in accordance move from five to three (budgetary) levels with budgetary priorities. 60 c h i n a 2030 Chapter 8 Achieving Mutually Beneficial r elations with the r est of the World China has benet fi ed enormously from global - global effects of the Great Recession might ization and by opening to the global econ- have been even worse than they were. In omy. Open trade policies worldwide helped addition, China’s outward foreign investment sustain global demand for Chinese products is playing an increasingly important develop- just as opening its market has sustained Chi- ment role in developing countries. nese demand for global products. China’s Going forward, this mutual dependence openness to foreign capital helped improve between China and the world economy will domestic economic efficiency by encourag - only increase. China’s large and growing mid- ing competition within China and provid- dle class will become an even more important ing access to cutting-edge technology. China source of global demand, the country’s indus- imported foreign practices in a host of areas trial upgrading and expanding trade will ranging from banking regulation to product lead to further specialization and increased standards. And substantial ino fl ws of foreign efficiency in world markets, and its increas - direct investment helped drive productivity in ingly educated labor force will become a domestic firms through competition, work - force for global innovation. It is now in the force training, and demonstration of new world’s interest to see a growing and thriv- technologies. ing China that will contribute a positive force Other countries have similarly benefited in support of global economic recovery and from China’s rise. The rapid growth of sustainable global growth. The world outside China’s exports has been largely driven by its China will change dramatically too. In 2030 participation in the global production value the contribution of other developing coun- chain; nearly half of its exports are process- tries to global growth will exceed 40 percent, ing trade—imports that are further processed far more than the contribution of all (current) and then exported—and multinational com- high-income economies together, which will panies that have invested in China produce contribute roughly one-third. This shift will more than half of its exports. Therefore, dramatically change China’s relations with its China is part of a broader success story in trading partners and its comparative advan- which enterprises from many countries and tage relative to other countries. territories have benefited, directly or indi- With this backdrop of mutual depen- rectly. Furthermore, China is now not only dence, China’s strategy toward the world the world’s second-largest import market, it will need to be governed by a few key prin- is also its fastest growing. Its strong demand ciples: open markets, fairness and equity, for raw materials, advanced machinery, and mutually beneficial cooperation, global inclu - consumer products has benefited developed siveness, and sustainable development. And and developing countries alike. China should help shape global governance At the same time, China’s relations with structures that will accommodate its own the world have changed over the past decade. evolution while promoting global growth It is now the world’s second-largest economy and providing opportunities for the develop- and its largest exporter. Its foreign exchange ment of other countries. As with other large reserves are the highest in the world, and economies, China’s long-term interest lies in they provide a large amount of sovereign debt global free trade and a stable and efficient financing for the United States and European international financial and monetary system. countries. China’s economy is now so large China benefited enormously from entering that its domestic policies have an impact on the WTO and is now an important stake- the global economy. If China had not imple- holder in the existing global trading system. mented such a strong fiscal stimulus pack- Similarly, it will want to see stable interna- age in 2009 and grown as robustly as it did tional financial markets and a well-regulated during the recent global financial crisis, the international monetary system supported over vie w 61 by stable currencies and underpinned by space as advanced countries and other emerg- sound monetary policies. And finally, ing markets. Reflecting these trends, the to ensure sustainable global growth, it is number of disputes in the WTO involving in China’s interest to work toward a global China has accelerated in recent years and climate change agreement that is fair and currently stands at 107 (78 as third party, 21 effective. as respondent, and 8 as complainant). These are expected to rise in the short term. The share of developing-country antidumping Key Issues in China’s External actions against China (as a share of their total Economic r elations actions) increased from 19 percent in 2002 to Notwithstanding slower growth in the 34 percent in 2009. advanced economies for the foreseeable With services rising as a share of GDP, future, greater integration with the global productivity growth in services will become economy will further increase China’s inter- increasingly important in maintaining over- national competitiveness in a number of all rapid growth, and this growth can be ways: through the specialization of Chinese boosted by further opening the services sec- manufacturing firms in the international tor to global competition. Moreover, a more value chain and greater economies of scale; efficient services sector will also advance the increased specialization and productivity in competitiveness of manufacturing as China services, where China would benefit from moves up the value chain. In stark contrast to more international competition; continued the important position China holds in global access to international technologies and trade is its virtual lack of presence in inter- greater participation in the global R&D net- national financial markets . In the next two work; and increased inward and outward decades, Chinese firms are likely to become foreign direct investment that would build on regional and global companies, and they will the comparative advantage between China need to invest and raise funds abroad. The and its trading partners. international presence of Chinese commercial The hard fact is that unless China moves banks and other financial institutions that up the value chain, the future contribution have close relations with Chinese firms can of exports to economic growth will decline help in this process. for three reasons. First, China’s penetration Moreover, China’s emerging multination- in key markets is already large, and further als will face new challenges as they seek to expansion of China’s market share is lim- become global players. China’s outward ited within the current export structure. flows of foreign direct investment have Second, rising costs for unskilled labor are climbed rapidly over the past decade. Even changing China’s international comparative as the stock of China’s foreign investment advantage within the export sector and will remains a minuscule share of the global require China to move up the value chain stock, efforts by Chinese companies to invest to remain internationally competitive. And, in other countries have already faced market third, reforms in input markets and natu- access restrictions in several countries, and these tensions are likely to rise. Such restric- ral resource pricing designed to correct dis- tortions will help increase the efficiency of tions are misguided, because Chinese multi- resource allocation, but, if labor productivity nationals can play an important role in a host does not increase to compensate for higher country’s development, by transferring tech- production costs, international competitive- nology and by integrating business practices ness will erode in traditional energy- and and organizational approaches. resource-intensive industries. China faces other challenges in its exter- As China moves up the value chain, it nal accounts. The combination of its current and capital account surpluses has resulted in will inevitably have to manage rising trade and investment tensions (in part, because of record foreign exchange reserves, exposing China’s sheer size). Increasingly, China will China to notably increasing risks from any compete internationally in the same product depreciation of the U.S. dollar or the euro 62 c h i n a 2030 and to limits on its macroeconomic policy increased from about 70 in 1990 to almost space to contain inflation and domestic 300 today; this poses a major challenge for overheating. China’s future trade because Chinese export- As its interactions with the global econ- ers are increasingly excluded from the same omy continue to intensify, China will need to preferential access as other exporters to key continue to protect its economic security and international markets. China should adopt respond properly to risks that arise in other a strategy of emphasizing both multilateral countries. The opening of the capital account and regional arrangements—abiding by and as part of a possible initiative to internation- protecting existing multilateral agreements alize the renminbi will, however, increase as well as pushing for further opening of international capital movements and sud- global markets using multilateral channels. It den changes in asset prices. China will also should also proactively push ahead with the be more reliant on imported energy and raw negotiations for accession to the WTO gov- materials, placing it at greater risk of supply ernment procurement agreement as part of disruptions arising from sharp price move- its effort to improve procurement procedures, ments in global commodity markets. And the enhance transparency, reduce costs, and wide and increasingly deep application of the enhance quality in government purchases. Internet and other information technologies At the same time, China needs to proactively will increase risks regarding information and participate in regional trade agreements that financial security. lower trade barriers at and behind borders Finally, China is becoming an important and introduce trade facilitation arrange- source of development assistance to other ments. Where possible, China should advo- developing countries, but its conditions, pro- cate “open regionalism,” which requires that cedures, and approaches differ noticeably tariff levels agreed among regional partners from those of some international donors. be offered to other nonmember countries on These differences did not matter when a most-favored-nation basis. China’s official development assistance was still small, but it is beginning to matter now Further opening of the services sector to and will be of increasing importance in com- international trade and investment. Not- ing years. China’s processes—on tying aid, withstanding rapid opening up of China’s transparency of terms and conditions, and services sector since its entry into the WTO, application of environmental and other safe- its policies on services trade remain more guards—will come under increasing scrutiny restrictive than policies in many developing as its development aid program grows in size. countries and much more so than in high- income countries. Further opening up the services market will help introduce advanced r ecommendations for Achieving technology and managerial expertise, pro- Mutually Benec fi ial Trade and mote reforms, increase competition, and Investment r elations ultimately enhance the efficiency and com - petitiveness of China’s services sector while, Improving the external economic and trad- at the same time, providing China leverage ing environment. Given its high trade-to- in international trade negotiations to further GDP ratio relative to other large economies, open the services markets of trading partners. the environment for international trade is crucial for China’s future development, so Promoting outward FDI. By becoming promoting an open global trading system global players, Chinese companies can cap- should remain an important policy objective. ture higher value-added segments of the In the absence of a successful Doha Round, global production chain and exploit econo- a multitude of bilateral and multilateral mies of scale. It can also be an effective free trade agreements have emerged around strategy in anticipation of increased scarcity the world (most notably in East Asia), and of low-skilled labor within China. More- the number of preferential agreements has over, increased outward FDI can limit the over vie w 63 FIg Ur E O.9 The renminbi is increasingly being continued expansion of foreign exchange used as the currency for cross-border trade reserves (in part to temper international settlement protectionist sentiment). To facilitate the globalization of Chinese firms, the govern - ment should further promote outward FDI 400 Import settlements (left axis) and perhaps even liberalize outward flows Export settlements (left axis) Share of total trade of portfolio capital. Bilateral investment (right axis) protection agreements could help create a better investment environment for Chinese enterprises investing abroad. Given doubts about foreign investments made by Chinese state-owned enterprises, the focus should be on promoting outward FDI by private enter- prises, thus enhancing their ability to oper- 0 0 ate internationally and, over time, to become Q3–Q4Q Q1 2Q3Q4 global companies. 2009 2010 China should also consider supporting a multilateral investment agreement that lib- Source: People’s Bank of China. eralizes FDI flows, provides basic guaran- Note: China’s total exports 2010: $1.75 trillion; China’s total imports 2010: $1.52 trillion. Q = quarter; RMB = renminbi. tees, and includes binding dispute resolution mechanisms. China’s contribution toward the shaping of such a multilateral agreement would be to ensure that the terms would is made flexible over time. The many prereq - be appropriate for developing-country cir- uisites for an open capital account was the cumstances. Achieving stronger protection main reason why many European countries and easier access for all investors, including took nearly 20 years after the collapse of the Chinese investors, would require granting Bretton Woods system to achieve full capital reciprocal concessions to foreign investors account liberalization. In the case of China, in China, implying a dismantling of most therefore, a relatively prudent approach, restrictions on FDI ino fl ws—something that stretching over many years, is recommended would also be in China’s long-term interest. in transitioning safely to a more open and efficient financial and exchange rate system. Steadily pushing ahead with the interna- tionalization of the renminbi. International- izing China’s currency will bring important A Stakeholder That Plays long-term benefits for China. The renminbi a Positive r ole in g lobal is already being used increasingly as the cur- g overnance rency for cross-border settlement (g fi ure O.9). If a substantial portion of China’s assets and With its growing share in the world economy trade were denominated in renminbi, then and its rising per capita income, China has u fl ctuations in the dollar-renminbi exchange become an essential partner in the provision rate would have few implications for domes- of global public goods. A growing number tic stability. But internationalizing the ren- of global problems cannot be solved without minbi requires opening the capital account, China’s active participation. China’s future and that can be done only after China has in prosperity depends to a large extent on the place a stable financial sector with improved capability of global collective action to make corporate governance in banks and other available key global public goods. It is in the financial institutions; well-functioning legal, common interests of the international com- supervisory, regulatory, and crisis manage- munity (and China) for China to become a ment frameworks; deep financial markets key proactive stakeholder in these global gov- with credible indirect monetary controls to ernance arrangements. The fact that China manage liquidity; and an exchange rate that is the second-largest economy in the world RMB (billions) Percent 64 c h i n a 2030 and yet ninety-third in terms of per capita to put policies in place—such as international income has created a huge gulf between the carbon trading—that are fair for developing world’s expectations about China’s ability to countries and create win-win solutions for the shoulder important roles and responsibilities world. Once carbon mitigation policies are in global governance and China’s perceptions implemented globally, incentives increase to of its own capabilities to do so. The process invent and implement new green technologies. of China’s participation in global governance The resulting technological progress and eco- will inevitably be gradual as the international nomic growth can potentially turn the reduc- community and China make constant adjust- tion of emissions into an opportunity instead ments to accommodate each other. of a burden. As China’s strength in the global economy China should proactively push for the rises, the international community will expect reform of the international financial system. China to play a more proactive role as a key China’s role in discussions on reforming the stakeholder in international governance rules international financial architecture should for trade and capital flows. In multilateral be to ensure that the final outcome not only negotiations, China could capitalize on its is consistent with China’s own plans to lib- unique position of straddling the interests of eralize its foreign exchange system, financial virtually the entire range of economies from sector, and capital account, but is also appro- low to high income. Its responsibilities will priate for developing country conditions correspondingly increase. China can also and suitable for strengthening the financial wield enormous influence in shaping these systems and the reduction of financial risks rules to ensure that they are supportive of in developing countries. For example, it is Chinese development. In particular, China’s necessary to assess the appropriateness of considerable impact on the global economy international prudential norms for China’s means that it can take, and would benefit financial system and their implications for from taking, a proactive stakeholder role in China’s interactions with global financial the design of such multilateral agreements. markets. Another example is the need to con- China should continue to proactively push sider the proposal of establishing a derivatives forward global climate change negotiations. clearing house and the capital needs for such China’s 12th Five Year Plan already includes institutions to ensure that they can reduce declining intensity of carbon dioxide emis- systemic risks facing China’s financial system. sions as a binding target. A fair and balanced China also needs to be an active stake- global climate agreement could leverage these holder in shaping the international aid archi- planned domestic actions by China, and make tecture. As China has become a more signifi - them more effective, without placing China at cant source of concessional assistance, it can a competitive disadvantage. China’s earnest better improve aid effectiveness, by further efforts to reach this target and establish a enhancing the transparency of its foreign aid market-based emissions reduction mechanism program, strengthening communication with within the country will provide a solid basis OECD donors, and enhancing aid project to help shape a global agreement and create management techniques. crucial win-win solutions. Failure on the part Finally, China should increase its partici- of major countries to reach agreement on pation, contribution, and predictability in climate change and contain the climate cri- global governance in the international com- sis will lead to serious consequences for the munity and play a role commensurate with world economy and, in particular, develop- its capabilities. Over time it can better play ing countries, including China, that are likely its role as an international stakeholder if it to be the most severely affected by climate strives to learn from the experience of other change. Such an agreement is also needed to major powers in global governance, train its create a level playing field and to avoid car - representatives in international governance bon tariffs, which can easily turn into pro- institutions to be world class, and enhance tectionist measures. China’s proactive role in the mechanism for and efficiency of internal the climate change negotiations is important coordination in international affairs. over vie w 65 Chapter 9 Overcoming Obstacles to Implementing r eforms So far, this report has described a proposed economic conditions, robust growth, and the medium-term reform program composed of largest stock of foreign exchange reserves in six new strategic directions to make China the world. Moreover, it has able and effective a modern, harmonious, creative, and high- central and local governments that have dem- income society. Reaching this goal is impor- onstrated strong capabilities for mobiliza- tant for China and for the world, but much tion, organization, management, and imple- mentation and, as in the past, can make the will depend on the design and direction of the important collective action decisions needed reforms as well as on their implementation. International experience shows that the to ensure successful outcomes. presence of a crisis may help a country reach internal consensus for action on reforms, but Sequencing r eforms it also tends to make reform costs high and outcomes uncertain. Crises narrow policy The six priority reform areas lay out objec- options, dictate the pace of reform imple- tives for the short, medium, and long term, mentation, and prevent adequate prepara- and policy makers need to sequence the tion. The advantage of appropriately timing reforms within and across these areas appro- and sequencing policy reforms is lost. In priately to ensure smooth implementation some cases, crises also set in motion events and to reach desired outcomes. that spin out of control and irreversibly shift Highest priority should be given to actions economies to a lower growth path. Con- that enjoy broad support, are likely to versely, initiating reforms proactively allows encounter little resistance, and are relatively adequate time for good policy design, appro- easy to implement. Examples include increas- priate sequencing, steady implementation, ing investment in human capital, encourag- and corrective actions when necessary. Yet ing public participation in the reform and proactive reforms tend to be opposed by development process, introducing a broad set vested interests, and reaching consensus is of indicators to assess economic, social, and difficult, requiring governments to be clear environmental progress and to measure the about objectives, communicating them well, performance of local governments. consulting widely, and working to overcome High priority should also be accorded to obstacles. actions that deliver “quick wins” and address In China’s current situation, the case for short-term risks. These actions include reform is urgent. The world economy is enter- increasing the flexibility of bank deposit and ing a dangerous phase in its recovery from lending rates and lowering high interest rate the global financial crisis, and the next five spreads; increasing SOE dividend payments years could prove to be particularly difficult. to the national budget; stopping forced con- At the same time, China’s economic, social, version of rural land for urban use, with any and environmental challenges are increas- conversions based on vetted urban plans, ing. China could postpone reforms and risk payment of market prices for acquired land, the possibility of an economic crisis in the and the introduction of a reasonable capital future—or it could implement reforms pro- gains tax; raising the retirement age for men actively. Clearly, the latter approach is pref- and women (which can be started soon but erable. Over the past three decades, proac- implemented gradually); removing fees for tive policy change has been key to China’s secondary education in rural areas; chang- economic success, and the calls for reforms ing local government growth targets from within the country have never been louder. In indexes based on GDP to those based on pushing for reforms proactively, China pos- “quality of growth”; raising energy, water, and carbon prices to reduce bottlenecks and sesses the considerable advantage of good 66 c h i n a 2030 shortages, encourage efficiency, and lower reforms and change always meet opposi- carbon emissions; and aggressively expand- tion. In China, this opposition is likely to ing public transport options. take many forms, and the policy response The next priority is for actions that will should be accordingly varied and flexible. In form the basis of future reforms, offer incen- summary, we identify three kinds of possible tives for innovation, and lay the foundations opposition. for future sustainable growth. These include The most resistant group is likely to be introducing fiscal transparency as well as vested interests—such as those enterprises independent and rigorous evaluation of pub- that enjoy partial or full monopoly (or mon- lic expenditures; mobilizing additional fiscal opsony) in key markets as well as firms, revenues, including by rapidly ramping up groups, institutions, and individuals who implementation of property taxation in urban obtain special privileges and benefits or areas; recentralizing expenditure responsibil- enjoy preferential treatment from the current ity for key social security programs, such as power structure and institutional setting. the basic pension system and unemployment These groups gain from a special relationship insurance, which will encourage labor mobil- with decision makers or reap economic rents ity and integrate the labor market; phasing from distortions implicit in the current price, out the hukou system; lowering entry and institutional, and administrative structures. exit barriers for firms; and imposing a carbon Not only are these vested interests unlikely to emissions quota, adopting tougher ecological surrender their privileged position easily, they and environmental standards, and introduc- are likely to be very influential, powerful, ing new building codes to meet energy effi - resourceful, and resolute in protecting their ciency and safety standards. interests. Overcoming such opposition will It is also important that the government require political courage, determination, clar- make breakthroughs in core reforms to ity of purpose, and adroit leadership qualities cement the foundations of a market economy at the highest level of the government. and form the foundations for the rest of the A second group that may oppose the reform program. The core of the program reform agenda are those who are likely to comprises the fiscal, financial, and enterprise be hurt from reforms in the short term, even reform components—key here are enterprise though they will gain in the long term. An reforms (especially measures promoting com- example would be those affected by the petition) and pricing reforms for natural proposal to reform the hukou system. In resources, including energy and raw mate- the long run, this reform would clearly be rials. Not only are these very closely tied to beneficial to China by helping to develop a one another, they are building blocks upon more integrated and efficient labor market which the innovation, environmental, and and also by lowering inequality in incomes social components rest. These core reforms and access to social services, which would are key to China’s efforts to consolidate the reduce social tensions. But urban hukou foundations of a market economy. Their suc- holders, driven by concerns that their privi- cess will determine the success of the other leged access to public services and social elements needed to achieve sustainable and security may be threatened, may not be sup- innovation-driven development. portive of these reforms. Similarly, work- In the medium term, efforts should focus ers in loss-making enterprises, energy- and on promoting innovation, green develop- pollution-intensive industries, and unregu- ment, and participation in the reform and lated financial institutions may think the support for global governance. reforms will hurt their economic interests. If this were to happen, the government could not only provide appropriate information Overcoming Opposition to and guidance but also allocate such groups r eform transitional assistance in the form of tem- Finally, as China knows only too well, and porary income support and training in new as is also the experience of other countries, skills. The government could also take steps over vie w 67 to ensure that local governments do not incentives introduced to assist those who may thwart or undermine the reforms by placing be hurt by structural reforms should be tem- local interests above national interests. porary, and the conditions for their termina- A third group is opinion makers who tion clearly established at the time of their equate today’s problems as outcomes of ear- initiation. lier reforms rather than of the distortions Finally, local governments and line min- that remain. Some, for example, attribute the istries should be allowed to experiment deterioration in the natural environment (air, with certain reforms within the framework water, land) to the market mechanisms rather of national policy objectives, and success- than to ineffective implementation of existing ful examples scaled up. China’s success in laws, rules, and regulations, or inappropriate previous reforms has built on the strength, price and incentive structures. Their impact flexibility, and adaptability of its institu- on public opinion is usually significant and tions. Its future institutional evolution should out of proportion to their small numbers. It continue to be firmly rooted within China’s is important that such inu fl ential voices have own reality and experience. Interest groups access to the thinking, analysis, and rationale that oppose change usually find it difficult underlying the reform program. Government to argue against success—and successful departments, think tanks, research institu- reforms at the local level tend to grow their tions, and universities should be encouraged own champions who see benefits from the to analyze reform issues and disseminate their new policies. Moreover, it is only through results. Indeed, involving the participation of learning-by-doing that implementation prob- civil society organizations not only will rally lems in reforms can be ironed out, so that support for reforms but could improve the when scaled up, the potential for opposition design of the reform program itself. is minimized. Winning over opposition to reforms will need to be a key part of the strategy and will Managing Macroeconomic r isks require a calibrated response depending upon and Vulnerabilities the reasons for the opposition. Strong lead- ership and commitment to the reforms will Macroeconomic and social stability is not provide important signals, facilitate coordi- only key for innovation, investor cond fi ence, nation across ministries and agencies, and and sustainable growth, it is also a fertile ensure that opposition to reforms is dealt environment in which reforms—short and with sensitively and effectively. long term—can achieve desired outcomes. As a practical matter, a high-powered Over the next 20 years, it is important that reform commission needs to be established China’s record of stability be maintained by—and with the full support of—the high- given the possibility of greater risks. These est level of government. This commission risks include greater susceptibility to exter- should be made responsible for the design nal economic shocks resulting from China’s and implementation of the reform pro - tighter economic integration with the world; gram. Only with such high-level support can weaknesses in government finances or in reforms be implemented steadily and with a the financial and enterprise sectors, which determined will. Commission members will might be revealed in a slowdown in China’s need to undertake extensive and genuine con- economic growth as it is transitioning from sultations and discussions with all stakehold- middle-income to high-income status; pos- ers so that everyone respects and understands sible social unrest, which could erupt in the the objectives of the reforms and the underly- face of perceived injustices; and greater dan- ing rationale for policy changes and so that a ger from natural disasters (rise in sea levels, proper balance is struck between the interests earthquakes, floods, droughts, tsunamis, of various stakeholders. At the same time, pandemics), which are likely to be magnified reforms should be designed so that they do by increasing urbanization. not create new interest groups supportive of Usually, risks are idiosyncratic, that is, distortive policies. Thus, fiscal or financial they occur randomly. But occasionally, they 68 c h i n a 2030 can be covariant or systemic, when they that capital ratios are adequate, nonper- occur together or have economy-wide effects. forming loans accounted for properly and Economies can usually cope with idiosyn- kept within prudential limits, and currency cratic risk, but covariant or systemic risks and asset-liability mismatches kept to a are more difficult to manage. China is well minimum. Balance sheets of banks, systemi- prepared to deal with idiosyncratic risks, but cally important state enterprises, and local governments should be able to pass a vari- it must anticipate the possibility of systemic risks and prepare appropriate responses. ety of periodic stress tests (such as interest Thanks to its impressive capacity for rate variability, exchange rate fluctuations, collective action, China has shown itself growth slowdowns, and capital flight). International experience has shown how to be particularly effective at dealing with macroeconomic shocks (including those quickly a small spark can ignite widespread from abroad). The challenge to China is social unrest. According to surveys in China, not whether it can respond well to crises the public’s trust in the judicial system and but whether it can further lower the risk of public services is very low, and social frus- tration has been building. This situation future crises. Indeed, all risks—natural, eco- nomic, or social—are essentially contingent points to the critical importance of building liabilities that can translate into actual lia- an impartial and effective legal and justice bilities for either government or households. system and improving equality of opportu- nity and accessibility to high-quality social Most important, measures to reduce risk are not only possible, they are usually cost- services. An essential element of reforms in effective. For example, adequate prudential these areas will be greater consultations and safeguards that prevent reckless behavior participation of the public in decision making and oversight of service delivery (including by in the financial and enterprise sectors can help governments avoid costly expenses in the justice system), increased transparency in the wake of a macroeconomic crisis; such the operations of these branches of govern- safeguards can reduce the probability and ment, and greater accountability to stake- the costs of a financial crisis. The benefits of holders and citizens. If one thing has been learned from sys- such measures are often orders of magnitude higher than their costs. temic crises, it is the importance of avoid- Notwithstanding government efforts to ing overconfidence and remaining vigilant ensure stability, the risk of macroeconomic against potential problems from social, eco- nomic, and natural causes. Countries need shocks and instability cannot be completely eliminated and will need to be dealt with to ensure that such vigilance is incorporated in a way that promotes medium-term into the national risk management system. reforms rather than sacrificing them. That can be done in five ways: When shocks occur, the policy response First, risk management requirements should depend on the cause. If growth should be embedded firmly in national regu - slows because of a temporary slowdown in lations, policies, and public investments. In demand, then countercyclical policies may addition, weaknesses in economic and finan - be appropriate. But if the potential growth cial systems should be probed constantly to identify where a crisis may arise and appro- rate decreases, then countercyclical policies would be inappropriate, and instead, addi- priate preventive action taken. Regular risk tional emphasis would need to be given to audits for critical parts of the financial infra - structural reforms. structure and systemically important enter- prises can reveal where structural or other The government should also take pre- ventive action to reduce the size of “shock flaws may expose the broader economy to amplifiers”—which tend to be high debt unnecessary risk. (including high contingent debt) ratios in Second, because risk management tends key parts of the economy such as banks, to cut across institutional jurisdictions, not firms, households, and governments. Care - only is coordination needed across different ful supervision of banks will need to ensure agencies and levels of government, so too is over vie w 69 clarity on who is responsible and accountable depend on the wisdom, strength, and deter- for what. mination of the Chinese leadership in press- Third, the government can and should ing ahead with reforms in the six key areas make information more easily accessible to highlighted in this report. help individuals, households, and firms take risk mitigation measures or preventive action. Notes Fourth, risk management institutions 1. The term “provinces” here includes munici- need to be capable of quick and decisive palities and autonomous regions that have the action when crises occur, be receptive to all same status as provinces. ideas from all sources, and be able to build 2. ht tp: //w w w.bankersalmanac.com /addcon partnerships for collective action, especially /infobank/bank-rankings.aspx). with communities that hold a stake in the 3. ht tp: //money.cnn.com /magazines /for tune outcome. /global500/2011/. Fifth, neither prevention nor mitigation 4. h t t p : / / a a p a . f i l e s .c m s -p l u s .co m / P D F s can completely eliminate risk, so insurance / WORLD%20PORT%20RANKINGS%20 is needed to soften the blow when macroeco- 2009.pdf. nomic disasters unfold. One insurance policy 5. Although the reputation of forecasting is is China’s already large external reserves. rightly in disrepute, even for the short term, let alone the medium or long term, national Another would be to keep adequate fiscal development strategies do need to consider space by maintaining a prudent public debt future trends in the global environment, dif- burden. A third would be strong supervision ficult as that may be. The authors recognize of the financial system. And a fourth would that discontinuities and shocks, by their very be a deposit insurance program that discour- nature, are difficult to anticipate. Ideas, tech - ages reckless lending and encourages prudent nologies, events, and individual actions can financial management, such as observance of sometimes snowball into powerful forces of capital requirements. change—the so-called “butterfly effect” that In managing social and macroeconomic occurs when initial conditions are such that a risks, three principles need to be kept in small change triggers large consequences. mind: the first is to guard against a retreat 6. Estimates of the scope of the middle class from the market mechanism and a return vary depending on the definition. The esti- mate quoted here is from Kharas and Geertz to administrative measures; the second is to (2010), who define the middle class as fall - press ahead with long-term reforms, because ing within the threshold levels of $10 a day structural factors usually lie at the root of to $100 a day per capita (measured in 2005 many of China’s periodic episodes of mac- PPP terms). roeconomic overheating; and the third is 7. The old age dependency ratio is defined as the to ensure that risk mitigation strategies are ratio of the number of people aged 65 years consistent with, and reinforce, the long-term and older to those aged between 15 and 64 strategy. years. China’s road toward a modern, harmoni- 8. During 1994–2009, particularly high TFP ous, creative, and high-income society will growth continued in part because of SOE be filled with challenges; but the goal has restructuring, WTO accession, and very suc- never been closer. The world’s economic cessful integration in the world economy of China’s manufacturing industry and associ- landscape will change when China becomes ated economies of scale. With a lower con- a high-income country. China’s rapid growth tribution expected from such forces, TFP and poverty reduction over the past three growth (excluding the contribution of human decades—achieved through domestic reforms capital formation), is expected to fall by half and opening up to the global economy—was a percentage point to 2.5 percent a year in nothing short of a miracle. The next two 2010–15 and ease thereafter to around 2 per- decades could witness another miracle in cent in 2026–30. By way of comparison, in which China’s economic, social, and cultural 1966–90, annual TFP growth in Hong Kong contributions will not only benefit China’s SAR, China; the Republic of Korea; Singa- own people but also contribute to global eco- pore; and Taiwan, China, averaged between nomic prosperity and stability. Much will 1.7 and 2.3 percent. This average includes the 70 c h i n a 2030 contribution of human capital accumulation, farmers with a plot located within a developed which is separated out in our analysis. urban area equivalent to 40 percent of the 9. The U.S. labor force numbers about 155 acquired land area. Such a program, however, million. The calculation assumes that over may incur administrative delays and lead to the next decade, China’s tertiary education very different outcomes for farmers affected completion rate rises to the advanced country by the same land acquisition transaction. average, where the advanced country average 22. OECD Stat Extracts: http://stats.oecd.org is determined based on data from Barro and /index.aspx?DataSetCode=REV. Lee (2010). 23. Based on data from Sam Ock Park (2009). 10. The population of Hong Kong SAR, China is 24. Sixth National Population Census, National around 7 million. Bureau of Statistics of China (NBSC), Peo- 11. B ased on the global wealth study prepared by ple’s Republic of China. the Boston Consulting Group (2011). 25. The amount of “surplus labor” in rural areas, 12. Estimate for 2010 using 2005 purchasing and therefore the number of potential rural- power parity prices based on staff calcula- urban migrants, is the subject of much study tions in Povcalnet (http://web.worldbank and controversy; see Knight, Quheng, and Shi .org / wbsite /ex ter n a l /ex tde c /ex t re s e a rch (2010). /extprograms/extpovres/extpovcalnet/). 26. There remain cases in very large cities where 13. The term “state dominance” goes beyond this process remains incomplete, such as in just state ownership and includes active state Beijing where applicants for government jobs involvement in investment and other manage- and for many enterprises require a Beijing ment decisions. hukou to be considered. 14. Unfortunately, the average prot fi ability of the 27. MOHRSS (Ministry of Human Resources rest of the SOEs cannot be calculated for lack and Social Security) data from end-2010. of data. 28. Sunrise industries are the opposite of sun- 15. T FP growth in the state sector was 1.5 per- set industries—relatively “young” industries cent a year, whereas the nonstate sector’s with future growth prospects, unlike sun- TFP grew at a rate of 4.6 percent a year; see set industries that are mature and likely to Brandt and Zhu (2010). decline in relative size. 16. For example, in 2006, state enterprises 29. The three key underlying concepts are that accounted for the production of all petro- growth and resource use can be “decoupled,” leum, natural gas, and ethylene; all basic tele- that the process of “going green” can itself be coms services; about 55 percent of electricity a source of growth, and that green develop- generation; and 82 percent of airline and air ment and economic growth could potentially cargo traffic (see Owen and Zheng 2007). reinforce one another. 17. A pure “public good or service” is one whose 30. World Bank estimates using 2008 data. In consumption by one individual does not addition, more than half of China’s water is reduce its availability for consumption by polluted, over 300 million people use con- others, and when no one can be effectively taminated water supplies, a third of China’s excluded from using the good. The term, as waterways are below the government’s own used in this report, applies to those goods safety standards, and about a fifth of China’s and services that, when produced or con- farmland has been contaminated with heavy sumed, result in positive externalities that metals (Ministry of Environmental Protec- are not remunerated, and hence tend to be tion 2011). underproduced. 31. For 2008, the last year for which data is 18. However, in some sectors such as telecoms, available. the splitting up was along geographic lines, 32. Several such taxes address negative exter- still leaving a single dominant provider in any nalities. Unlike many other taxes, such taxes given area. present few if any trade-offs when viewed in 19. Land Resources Statistical Yearbooks 2002– 09, a more holistic way than through GDP alone, published by the Ministry of Land Resources. because they make prices better reflect the 20. The National Audit Office report is avail- true marginal cost of a particular activity, able at http://www.audit.gov.cn/n1992130 including the damage to environment. /n1992150/n1992500/2752208.html. 33. Zhang (2010) provides a detailed discussion 21. An alternative approach could be the one on SOE dividend policy and international adopted by Korea, which provides affected practices. over vie w 71 34. Furthermore, the “revenue productivity” of Barro, R. J., and J. W. Lee. 2010. “A New Data Set of Educational Attainment in the World, personal income taxes (PIT), measured as the 1950–2010.” Working Paper 15902, National revenue collected as a share of GDP divided Bureau of Economic Research, Cambridge, by the weighted average PIT rate, is only 15 MA. percent of global averages and 11 percent of Baumert, Kevin A., Timothy Herzog, and Jona- high-income country averages. than Pershing. 2005. 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Within-firm the past three decades has brought many improvements in technical efficiency can positive results and set the country on a path be generated by technological innovation, to become a high-income economy. But the better management, exploitation of scale pattern of growth has introduced new eco- economies, agglomeration economies linked nomic, social, environmental, and external to successful urbanization, and productivity challenges that could ultimately slow growth improvements spurred by enhanced compe- and work against the stated goal of building tition. Improvements in allocative efficiency a “harmonious society.” would come through the movement of factors To become a high-income economy by of production from lower to higher produc- 2030, China will need to sustain relatively tivity uses (firms, sectors, locations). Better rapid economic growth. However, three resource allocation would sustain the pace, factors look set to contain growth going alter the pattern, and boost the quality of forward. First, the contribution from labor growth. Such efficiency gains have been an will decrease in line with lower and eventu- important part of China’s growth story to ally negative expansion of the working-age date and are far from exhausted. To unleash population. Second, the need to achieve such efficiency gains, China needs to move more “intensive” and more balanced growth from a growth model appropriate for a period may require a gradual decline in the ratio of of “catch up” to one driven by efficiency and investment to gross domestic product (GDP), innovation. Building on modeling results, the albeit the ratio will remain at very high levels. report argues that sustained reforms could Third, the scope for gains in total factor pro- deliver growth rates that, while lower than ductivity (TFP) from rapid factor reallocation those of the past three decades, will still and the simple copying or transfer of technol- allow China to join the group of high-income ogy will taper off as China approaches the countries by 2030. later stages of industrialization. However, as long recognized by China’s In this setting, the key to sustaining rel- leaders, growth is no longer enough. Simul- atively fast growth will be keeping the rate taneously achieving a “harmonious society” of increase in TFP growth near its past high will also require progress in making growth rates, through policies and reforms to further more equitable, environmentally sustainable, 77 78 china 2 0 3 0 and balanced. Specific challenges include protection, health care, environmental pub- creating conditions for more employment lic investment, and recurrent expenditures, generation and for improvements in “the dis- mostly by subnational governments. How- tribution of primary income,” in the quality ever, such increases will need to be achieved of and access to public services, in expanded while maintaining fiscal sustainability, avoid - social security and other reductions in vul- ing levels of taxation that could harm growth, nerability, and in efforts to create a less easing the fiscal pressures on subnational resource-intensive form of growth. governments, and strengthening fiscal insti - Indeed, the report shows how concerted tutions. Over the next two decades, then, the reforms to address key remaining distor- challenge will be sixfold: changing the com- tions can put China on a development path position and improving the efficiency of pub - that delivers both relatively fast growth and lic expenditures in line with China’s evolving improvements in key social, environmental, development objectives; improving the effi - and external indicators. In contrast, such ciency of revenue mobilization; realigning an outcome is inconceivable under broadly revenues with expenditure responsibilities by unchanged policies. In fact, an attempt to sus- raising selected functions to higher levels of tain the past growth model for an extended government and allowing some governments period could lead to a forced change in course to charge local taxes; bringing on budget all as China finally reaches some of the limits of subnational government borrowing and the economic, social, environmental, or external associated spending, and putting them under sustainability. Whether through a controlled strict controls; equalizing subprovincial trans- change in policy or through a crisis, such a fers across lower levels of government; and hasty shift would lead to sharply lower sav- improving the accountability and transpar- ings and investment rates, putting China on ency of governments. a slower growth path. This reality further strengthens the case for proactive reforms. The enterprise sector. A vibrant corporate Such fundamental policy reforms will need sector will be critical for sustaining relatively to go hand in hand with increases in some fast growth. The central elements will be categories of public spending. These needed further increases in competition, especially increases have two implications. First, the fis - (but not only) between the state and nonstate cal system needs to be strengthened to help (including private) enterprises in the “stra- deliver the level and quality of public social, tegic” and “pillar” industries where compe- environmental, and infrastructural services tition has been curtailed, and redefinition deemed central to the vision of China 2030. of the function of state capital. To promote Second, public resources will need to be the securitization and trading of state capi- raised efficiently and allocated in a way that tal, state capital should be used solely for the rapid growth is maintained even as China provision of public goods and services. This approaches the technology frontier in a num- reform requires restructuring the state-owned ber of sectors. This is a bigger challenge than enterprise (SOE) sector, dismantling monopo- it may appear at first blush since many other lies and oligopolies in sectors where competi- constraints to growth—including an anemic tion would yield superior results, introducing global economy and a shrinking and aging oversight arrangements where monopolies labor force—also need to be overcome. This are considered necessary to ensure that mar- report argues they can be overcome through ket power is not abused and does not act as reforms in China’s enterprise sector as well as a drag on the economy, and lowering entry in its input markets—land, labor, and capital. and exit barriers for all enterprises. Improved allocative efficiency will also require fur - The fiscal system. The large social and envi- ther efforts to level the playing field, espe - ronmental agenda over the next two decades cially between smaller and larger firms, and will entail significant expansion of social between state-owned and nonstate firms, not c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 79 only in a legal sense, but also in the access to and effective regulation and supervision. In key inputs. The portfolio of SOEs should be addition, there is a need to further liberal- diversified, some state shares should be sold in ize interest rates; deepen the capital market; the market over time, and modern corporate upgrade financial infrastructure and the governance practices should be exercised in legal framework; strengthen the regulation SOEs. Finally, this restructuring will require and supervision framework; build a financial a review and modernization of the extensive safety net and develop crisis management and “industrial policies” that the authorities have insolvency schemes; and recast the rights and used to inu fl ence the structure within and responsibilities of government. across sectors. These reforms are united by one com- mon theme—“reforming government.” For The allocation of factors of production. If much of the past three decades, and unlike in anything, improving the efficiency in the use countries that belong to the Organisation for of factors of production—land, labor, capi- Economic Co-operation and Development tal—will be more challenging than reforming (OECD), government has maintained a direct the enterprise sector. However, this sphere is role in allocating resources, with instruments also the one in which many significant distor - such as industrial policy and state ownership tions remain, suggesting much potential from leading to tight interconnections between reforms to improve resource allocation. governments and enterprises. In contrast, in In land, the principal challenges are to health, education, social security, and other enhance security of rural land tenure and areas typically considered to require state to ensure the equal treatment of rural and involvement because of market failures, Chi- urban land tenure and property rights for na’s government had initially retreated. Tra- social stability, particularly in rural areas; to ditional arrangements were abandoned, and modernize the institution of the rural collec- government spending lagged behind. The tive so that it remains relevant in the face of report identifies specific ways in which the evolving shifts in law and policy; to address role of the government can be recalibrated, the strict separation of rural and urban land generally toward a more limited direct role in tenure systems, which currently drives the resource allocation, a more arm’s-length rela- inefficiencies and inequities generated by the tionship between government and business, process of converting rural land into urban and an enhanced role in delivering public use, by reducing the role of state in the land goods and services and ensuring equality of conversion process and by allowing for more opportunity. Reviewing the interrelationships market-based allocation of land; to ensure between various tiers of government will play the protection of priority farmland for food a key role in this recalibration. security through comprehensive land use planning; and to introduce taxation of land Setting the Stage: China’s Past and property to help ease the distortions and Economic Performance, Key social pressures created by subnational gov- Challenges, and Future Growth ernments’ reliance on revenues from land transfer fees. Potential The financial sector faces a few key reform Rapid Past Growth and its Sources challenges. First, there is a need to commer- cialize and rationalize financial institutions China’s remarkable economic development and markets to meet the diverse demands of over the past three decades has brought many households, enterprises, and government sec- positive results. Growth averaged 10 percent tors for financial services and products. To a year, far faster than in nearly any other this end, financial institutions should be bet - country. This growth drove a parallel reduc- ter governed and operate in a conducive pol- tion of the poverty rate from 65 percent to icy environment under competitive pressure well below 10 percent (World Bank 2009a). 80 china 2 0 3 0 As a result, China has become the world’s economic, social, environmental, and exter- second largest economy (accounting for 9.5 nal challenges that work against the govern- percent of global GDP in 2010), its largest ment’s stated goal of building a “harmonious exporter (with a global market share of over society.” Spurred by high savings, cheap 10 percent and rising) and manufacturer, and finance and other inputs, and export-oriented an increasingly important engine of global policies, China’s growth has been investment- growth. and industry-led. The priority accorded to As elaborated in annex 1A, China’s fast industry stunted the development of services, growth can be explained from various per- while the emphasis on physical investment spectives. It was a type of growth char- led to lower investment in human capital. In acteristic of a catch-up phase, where the turn, highly capital-intensive growth meant combination of government-driven resource that China’s economy created few jobs per mobilization and pragmatic and effective unit of urban GDP growth. With wages lag- market-oriented reforms allowed the country ging behind productivity growth, the share of to exploit the “advantages of backwardness.” wage income in GDP declined to 48 percent Additional factors such as China’s large mar- by 2008, driving the share of consumption ket size, a “demographic dividend,” the suc- in GDP to unprecedentedly low levels for a cessful harnessing of globalization, and a major economy. These trends contributed to large and disciplined workforce contributed high and widening income disparities. Social to China’s boom in manufacturing. Market- imbalances were exacerbated by pronounced oriented reforms unlocked a vast pool of unevenness in access to public services and entrepreneurial talent, which further contrib- by tensions surrounding land acquisition. uted to vigorous growth. On the environmental front, rapid growth, While the market mechanism was con- a shift in production toward more energy- tinuously expanded and now plays the lead intensive industries, and urbanization have role in resource allocation, the government combined to make China the world’s larg- has played a strong role during China’s eco- est energy user. Fast growth has also led to nomic take-off. In general, the government substantial depletion of natural resources has used its regulations and powers in ways and serious environmental pollution. Finally, that favor the extensive input of capital and many of the policies that generated China’s other factors to foster fast industrialization internal imbalances also contributed to its and urbanization. The government’s focus on twin current and capital account surpluses. expanding industrial investments has helped Together with China’s expanding global mar- to promote reallocation of factors from low- ket share, they fueled protectionist pressures productivity agriculture to higher-productiv- in key foreign markets. ity manufacturing. Over time, however, the government’s strong role, especially its inu fl - Avoiding the “Middle-Income Trap” ence on factor allocation, has contributed while Addressing Key Imbalances to ever more serious economic imbalances and social disharmonies. Going forward, To become a modern, harmonious, and cre- this strong role can also be detrimental to ative high-income society by 2030, China improvements in technical efficiency, cre- will need to sustain relatively rapid growth ative power, and entrepreneurship at a time while addressing the noted economic, social, when China’s growth will depend more on environmental, and global imbalances. In innovation. countries near China’s level of per capita GDP, the first challenge is often termed that of avoiding the “middle-income trap” (Gill The Emergence of Imbalances and Kharas 2007). This rapid growth and the accompany- Two factors are set to contain China’s ing structural change, while serving China growth rate going forward. The contribution well in many respects, also introduced new from labor will decrease in line with lower, c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 81 and eventually (from around 2015) negative, reforms to further improve the efficiency of expansion of the working-age population. China’s economy. Without new impulses Similarly, if some income will be trans- to raise TFP, growth could slow rapidly, ferred from enterprises to households either exposing China’s economy to heightened because of a need to achieve social objectives risks. Within-firm improvements in techni - or because of a tightening labor market, and cal efficiency can be generated by techno- if growth must become more “intensive” to logical innovation, better organization and meet environmental goals, the ratio of invest- management, exploitation of scale econo- ment to GDP could gradually decline, albeit mies (including from consolidation of sup- still remaining at very high levels. In addi- ply chains), agglomeration economies linked tion, somewhat lower investment rates will to successful urbanization, and productivity reduce the scope for the transfer of tech- improvements spurred by enhanced competi- nologies embedded in new equipment. In tion. Parallel improvements in allocative effi - any case, as China moves from a technologi- ciency would come through the movement of cal “catch-up phase” toward the frontier, a factors of production from lower- to higher- smaller share of productivity improvements productivity uses (firms, sectors, locations). will take such embedded form. Better resource allocation would sustain the In this setting, the key to avoiding the pace, alter the pattern, and boost the qual- middle-income trap is keeping TFP growth ity of growth. As elaborated in box 1.1, such near its past high rates, through policies and efficiency gains have been an important part Box 1.1 Significant potential remains for further productivity gains through factor reallocation Several detailed studies of China’s past performance be the key driver of growth. They also find signifi - support the conclusion that factor reallocation has cant misallocation of capital, with the less efficient been a major contributor to its productivity growth. state sector absorbing over half of all fixed invest - Hsieh and Klenow (2009) seek to measure the ment, while representing only 13 percent of employ- degree to which resource misallocation has lowered ment. The authors calculate that if capital had been aggregate total factor productivity (TFP) in China allocated efficiently across the state and nonstate and India. They model how distortions that drive sectors, with more going to the latter, China could wedges between the marginal products of capital have achieved the same growth without the observed and labor across firms will lower aggregate TFP. increase in the rate of aggregate investment from Using microdata, they find large gaps in marginal 21 percent of GDP in 1978 to 40 percent in 2007. products of capital and labor across plants within Looking forward, reducing distortions in capital narrowly defined industries in China compared with markets could help China maintain relatively rapid the United States. By hypothetically reallocating growth while simultaneously reducing the imbal- capital and labor to equalize marginal products to ances between consumption and investment. the extent observed in the United States, they cal- Bai, Hsieh, and Qian (2006) also look at the dis- culate potential manufacturing TFP gains of 50.5 persion of returns to capital across sectors, regions, percent in China in 1998. By 2005, these potential and types of ownership. They find clear evidence gains had been reduced to 30.5 percent, indicating of misallocation but also some evidence that it may progress in improving resource allocation in the have lessened over time, thus contributing to China’s intervening period as well as large remaining scope growth performance. Bulman and Kraay (2011) find for further improvements. that factor reallocation has accounted for about 2.2 Brandt and Zhu (2010) seek to quantify the percentage points of growth over the period 1979– sources of China’s past growth. The authors con- 2008, or more than one-half of the total growth in sider three sectors: agriculture, the state part of non- TFP. This contribution appears to have been on a agriculture, and the nonstate part of nonagriculture. declining trend. They find the increase in TFP in the latter sector to 82 china 2 0 3 0 Box 1.2 How fast will China need to grow to achieve high-income status by 2030? Between 1989 and 2009, the World Bank thresh- exchange rate appreciation is 0.8 percent a year, and old between upper-middle-income and high-income 4 percent average real GDP growth if real exchange countries grew by an average of 3.5 percent a year rate appreciation is 3 percent a year. (nominal U.S. dollars). Assuming that this threshold Alternative assumptions about each indicator continues to grow at the same rate, the high-income are easy to apply in this simple framework. For threshold in 2030 would be $24,079 per capita. To example, if the threshold were assumed to grow by reach this level by 2030, China’s GDP per capita in around 4.5 percent a year instead of 3.5 percent, dollars would have to grow at an average of 8.9 per- the required GDP growth rate would rise to 5–7.2 cent a year. Based on a projected population growth percent. Similarly, targeting a 2030 GDP per capita of 0.4 percent a year, this would require average 10 percent above the formal high-income threshold GDP growth of 9.3 percent a year, in dollar terms. would require a 0.5 percentage point higher average Assuming 2.3 percent U.S. inflation, average annual growth rate. real GDP would have to grow 6.2 percent if real of China’s growth story to date. They are Japan, Republic of Korea, and Taiwan, China, far from exhaustion, however, and can be over periods when their per capita GDP rela- unlocked through further reforms. tive to that of the United States was similar to China could formally reach high-income that of China today. In a recent multicountry status with average GDP growth rates quite review of growth performance, Eichengreen, a bit below those it achieved over the past Park, and Shin (2011) project China to grow three decades. The threshold beyond which by 6.1 to 7.0 percent a year in the 2011–20 an economy is deemed to be high, middle, decade and by 5.0 to 6.2 percent a year over or low income is naturally arbitrary. None- 2021–30. Finally, Lee and Hong (2010) fore- theless, the World Bank employs such cast average growth over the period 2011–30 thresholds for classifying its client mem- of 5.5 percent under a “baseline” scenario bers. Box 1.2 provides illustrative calcula- and 6.6 percent under a “reform” scenario. tions of the growth rates needed to carry Our own projections (given later) imply aver- China to the Bank’s high-income threshold age growth of 6.6 percent over the next 20 by 2030. Because global growth is mov- years under a reform scenario, also suggesting ing this marker, while the relevant Chinese that such a target is within reach. growth rate is the product of domestic GDP However, growth is no longer enough. growth and the evolution of the yuan-dollar Simultaneously achieving a “harmonious exchange rate, these calculations produce a society” along with high-income status will range of estimates from 4 percent to 6.2 per- also require progress in making growth more cent. Reaching a higher level above this very equitable, environmentally sustainable, and minimal threshold would require faster aver- balanced. Specific challenges include creat - age growth; the average per capita income ing conditions for more employment genera- of high-income countries is more than three tion and for improvements in the distribution times this threshold level. of “primary income,” in the quality of and Prominent projections of China’s future access to public services, in expanded social potential growth bracket this range of growth security and other means of reducing vulner- rates, suggesting that high-income status by ability, and in efforts to create a less resource- 2030 is achievable. For example, Lin (2011) intensive form of growth. argues that China could still grow at around China’s top leaders have long recog- 8 percent a year over the next 20 years, based nized this need. As a result, the need for a on a comparison with the performance of new growth model has been the paramount c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 83 objective of all key government policy state- A reform scenario that assumes substan- ments since the annual Central Economic tial policy reform along the lines sketched out Work Conference of December 2004. The in the report is first developed and quantified. following year, changing the growth pattern We then consider alternative, more qualita- became an overarching thrust of the 11th tive scenarios where such reform is not forth- Five Year Plan (5YP) 2006–10. In a major coming or is of lower quality. shift from previous plans, where growth was Under the modeled reform scenario, over- the dominant objective, the 11th 5YP also all GDP growth would slow over time, but to emphasized environmental and social objec- rates that still could ensure high-income sta- tives. While some progress has been made, tus by 2030. All the main drivers of growth the agenda is far from complete (World Bank evolve gradually. Although more employ- 2009c). These aims have now been main- ment-friendly labor market policies and more tained and reinforced as central pillars of the labor-intensive production allow employment 12th 5YP. The need for more fundamental to grow slightly faster than the working-age structural change to achieve such objectives population, demographic factors still cause has also long been stressed by many analysts employment to begin shrinking around 2015. of China’s economy. With the beneficial impact of opening up the economy and integration into the world econ- omy expected to phase down, with China Possible Scenarios to 2030 moving closer to the technological frontier, This understanding is also supported by the and with declining potential to remove dis- results of economic modeling, which deliver tortions, TFP growth edges down over time, two strong messages. The first is a posi- although to a still high level by regional tive one. Concerted reforms to address key standards. Finally, the contribution of capi- remaining distortions can lead China to a tal accumulation to growth also declines but development path that delivers both rela- remains sizable. Restructuring the economy tively rapid growth and improvements in key takes time, while the need remains for high structural, social, environmental, and exter- levels of manufacturing activity and for fur- nal indicators. Second, and in contrast, such ther investment, notably in infrastructure an outcome is inconceivable under broadly but also for industrial upgrading. The capi- unchanged policies. Under such a scenario, tal stock per worker is now an estimated 8.7 while growth could still remain relatively percent of the U.S. level, underscoring the high, key social, environmental, and external need for further capital accumulation. GDP indicators would worsen significantly. growth would gradually decline from an How might China’s economy evolve over average of 8.6 percent in 2011–15 to an aver- the next 20 years under a scenario of substan- age 5 percent in 2026–30. tial additional reform? Given the fundamen- Such a growth slowdown would be inde- tals, how high could trend growth be? How pendent of policies to transform the economic would the structure of the economy evolve? development pattern. Relative to an alter- To examine the impact of different long-run native “on past trends” scenario described strategies on the speed and quality of China’s below, this scenario features significantly future growth (including on resource use, lower investment, hence a smaller contribu- income inequality, and the external balance), tion from capital accumulation. However, the Development Research Center (DRC) of this effect would be broadly offset by still the State Council has updated its computable high TFP growth, driven by factors such as general equilibrium model, which incorpo- more reallocation of labor (both across firms rates the detailed structure of production, and from rural to urban areas), more finan - demand, income distribution, and resource cial sector reforms, better corporate gov- use in China to conduct illustrative alterna- ernance, fewer distortions and barriers to tive long-term scenarios. services sector activities, more research and 84 china 2 0 3 0 TABLE 1.1 China: Projected growth pattern assuming steady reforms and no major shock Percent Indicator 1995–2010 2011–15 2016–20 2021–25 2026–30 GDP growth (annual) 9.9 8.6 7.0 5.9 5.0 Labor growth 0.9 0.3 –0.2 –0.2 –0.4 Labor productivity growth 8.9 8.3 7.1 6.2 5.5 Structure of economy (end of period) Investment/GDP ratio 49 42 38 36 34 Consumption/GDP ratio 47 56 60 63 66 Share of industry in GDP 46.7 43.8 41.0 38.0 34.6 Share of services in GDP 43.1 47.6 51.6 56.1 61.1 Share of employment in agriculture 36.7 30.0 23.7 18.2 12.5 Share of employment in services 34.6 42.0 47.6 52.9 59.0 Sources: NBSC and DRC. development (R&D), and more development investment, the current account surplus of human capital. gradually declines over time, as a share of Over a 20-year horizon, this scenario also GDP, easing external imbalances. sees significant changes in the structure of • The economy creates more urban jobs and, the economy, supporting a reduction of eco- as a result, more rural-urban migration, nomic, social, environmental, and external higher rural productivity and income, imbalances (table 1.1). Key specific trends and less urban-rural inequality. More include: urbanization stimulates the service indus- try, including through spending patterns • The importance of industry declines and of urban residents. The share of employ- that of the service sector rises. The share ment in agriculture falls to 12.5 percent of industry in GDP gradually declines by in 2030. This decline works to support 12 percentage points, from 47 percent in the growth of labor productivity in agri- 2010 to 35 percent in 2030, while that of culture, hence income growth in that sec- the tertiary sector rises by a significant 18 tor. The decrease in the productivity gap percentage points from 43 percent in 2010 between agriculture and the other sec- to 61 percent in 2030. tors underlies lower urban-rural income • The share of consumption in GDP rises inequality. from 47 percent in 2010 to 66 percent in • The economy will be less commodity and 2030, reversing the past steady decline. energy intensive. That is because it has less Reforms that encourage urban job cre- industry and, within industry, less heavy ation and greater upward pressure on and dirty industry, in large part because of wages boost the share of wages and house- better pricing of energy, commodities, and hold income in GDP, increasing the role of environmental degradation. household consumption. Government con- sumption rises on the back of increasing Alternative scenarios are possible. Differ- social spending and spending on opera- ences in global developments would naturally tions and maintenance. affect China’s prospects. Because the result- • Investment as a share of GDP declines ing possible range of domestic exogenous and over time. This ratio trends down by 15 policy scenarios is vast, we discuss the key percentage points to a more sustainable features of these alternatives in more qualita- 34 percent in 2030, well below both cur- tive terms. rent levels and levels under any alternative One alternative domestic scenario would “on past trends” scenario. Despite lower see much less progress with economic c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 85 restructuring. Under this “on past trends” to more reliance on markets and entrepre- scenario, policy settings and trends would neurship, and from technology absorption remain broadly unchanged. As a result, fac- to technology innovation, while simultane- tors and resources would continue to be ously correcting economic imbalances and channeled toward industry, with the share of social disharmonies. Doing so will require a industry in GDP edging down only slightly sense of the policy areas that offer particular between 2010 and 2030. The share of ser- promise for promoting rapid and harmonious vices would still increase, but to a low level development and of the specific reforms that compared with countries at a similar stage would be required. This report now turns to of development. Already very high invest- examining such issues. It argues that these ment and savings would increase further and reforms will need to focus on three broad already very low consumption would decline areas that promise particularly significant further. Overall, the current account surplus gains in efficiency or reductions in imbal- would remain high despite increasing levels ances. First, the enterprise sector needs to be of investment. Labor migration out of agri- further reformed to facilitate more efficient culture and urbanization would continue, resource use and motivate innovation and but at a slower pace. More modest urban entrepreneurship. Second, reforms of input job creation would limit the increase in the markets—land, labor, and capital—need to household income share, while the labor be advanced to rectify distortions in factor productivity gap between agriculture and allocation. Third, the fiscal system needs to the rest of the economy would remain high. be improved to help sustainably deliver the Both factors would further accentuate urban- level and quality of public social and environ- rural income disparity and overall inequality. mental services central to the vision of China Finally, in this industry-led scenario, energy 2030. The remaining resources available for and resource intensity would remain high, investment will need to be raised and allo- and pollution and emissions would continue cated so that rapid growth is maintained even to rise. as China approaches the technology frontier In fact, continuing with the past pattern in a number of sectors. would become increasingly difficult, if not These reforms are united by one com- impossible. While this scenario can be mod- mon theme—“reforming government.” For eled, a more likely outcome would be a future much of the past three decades, while the forced change in course as China finally market mechanism has been demonstrating reaches some of the limits of economic, its effective function in allocating resources social, environmental, or external sustain- and spurring economic growth, the govern- abilit y. Whether through a controlled ment has maintained a direct role in allocat- change in policy or a crisis, such a hasty ing resources and deciding business affairs. It shift would lead to sharply lower savings and does so by maintaining significant ownership investment rates, putting China on a slower stakes in some important enterprises in “stra- growth path than under the reform scenario. tegic” sectors and by deploying a range of This possibility further strengthens the case industrial interventions to inu fl ence resource for up-front reforms to get China on a new allocation. It also exercises complicated reg- growth path. ulations and oversight to channel factors at low cost into industrialization and urbaniza- tion. In contrast, in health, education, social Promoting Efficiency and Equity security, and other areas typically considered through Structural Reform to require government involvement because of market failures, China’s government had Changing the Role of the State initially retreated. Traditional arrangements To achieve its vision for 2030, China needs were abandoned, and government spend- to shift from factor input-driven to efficiency- ing lagged behind. Also many public entities driven growth, from direct state intervention such as hospitals and schools had to “fend for 86 china 2 0 3 0 themselves,” becoming responsible for their role of government in input markets, in state own revenue generation. ownership of companies, and in industrial China’s strong track record under the and competition policies. At the same time, existing policies, especially its relatively good in line with the aim to become a harmonious performance during the recent global crisis, society, there is scope for more government is no reason to avoid reforming government. involvement in health, education, and social China’s past success was the combined result security. Reviewing the interrelationships of market and government forces and actions. between various tiers of government will play A strong government used direct interven- a key role in this recalibration. tions to push forward industrialization and urbanization, to overcome market failures, From Catch-Up Growth to and to facilitate factor accumulation while Endogenous Growth the market unleashed the power of the enter- prise sector. As described by economists like Government reform will be crucial for help- Gerschenkron (1962) and Rosenstein-Rodan ing China move from its previous catch-up (1961), such policies to reap the “advantages growth approach to a more endogenous of backwardness” are not unusual. However, development approach. So far, this shift as China approaches the general technologi- has proven very challenging. While a 2003 cal frontier and finds it harder to sustain an plenum of the Communist Party of China extensive form of growth, this previous (CPC) vowed to transform the government’s advantage can become the disadvantage. function in economic management (espe- Over time, specific incumbent enterprises can cially through reform of the administrative solidify their privileged access to resources approval and investment systems), limited and government support. In China, many progress has been made. Going forward, such firms are larger state-owned enterprises, such progress in government reform will be because SOEs are naturally connected to the promoted by reform of the fiscal system, the government and often seen as strategically enterprise sector, and factor allocation. important. This biased business environment can jeopardize fair competition, efficiency The fiscal system. The large social and envi- improvement, and innovation and thus be an ronmental agenda over the next two decades obstacle for an economy trying to complete will entail significant expansion of social its industrialization and join the club of high- protection, health care, public investment in income countries. The economic imbalances the environment, and recurrent expenditures, and social disharmonies will also become mostly by subnational governments. How- more and more difficult to handle. ever, such increases will need to be achieved The report identie fi s specic w fi ays in which while maintaining fiscal sustainability, avoid - the role of the government and its relation- ing levels of taxation that could harm growth, ship with enterprises can be recalibrated to easing the fiscal pressures on subnational achieve rapid sustained growth driven by effi - governments, and strengthening fiscal insti - ciency and innovation. It calls generally for tutions. Over the next two decades, then, the moving toward a more limited direct (more challenge will be sixfold: changing the com- arm’s-length) role in resource allocation and position and improving the efficiency of pub - an enhanced role in delivering public goods lic expenditures in line with China’s evolving and services and ensuring equality of oppor- development objectives; improving the effi - tunity. As economic development progresses, ciency of revenue mobilization; realigning markets function increasingly well, and the revenues with expenditure responsibilities economy becomes increasingly sophisticated, by recentralizing some selected functions the benet o fi f direct government involvement and allowing some subnational governments in allocating resources weakens. In this con- to charge local taxes; bringing all subna- nection, it is useful for China to review the tional government borrowing and associated c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 87 spending on budget, subject to strict controls; efficiency will also require further efforts to making subprovincial transfers more equal- level the playing field, especially between izing across lower levels of government; and smaller and larger firms, and between state- improving the accountability and transpar- owned and nonstate firms, not only in a legal ency of governments. sense but also in the access to key inputs. Finally, this will require a review and modern- The enterprise sector. A vibrant corporate ization of the extensive “industrial policies” sector will be critical for sustaining relatively that the authorities have used to inu fl ence the fast growth. A central element will be further structure within and across sectors. increases in competition, especially (but not only) between the state and nonstate (includ- The allocation of factors of production. If ing private) enterprises in the “strategic” and anything, improving the efficiency in the use “pillar” industries where such competition of factors of production—land, labor, capi- has been curtailed. The role of state capital, tal—will be more challenging than reform- after being securitized and made tradable, ing the enterprise sector. However, as shown should be calibrated to provide public goods. in box 1.3, this is also the sphere in which That requires dismantling monopolies and many significant distortions remain, suggest - oligopolies in sectors where competition ing much potential from reforms to improve would yield superior results, introducing over- resource allocation. sight arrangements where monopolies are con- In land, the principal challenges are to sidered necessary to ensure that market power enhance rural land tenure security and ensure is not abused and does not serve as a drag on the equal treatment of rural and urban land the economy, and lowering entry and exit bar- tenure and property rights for social stabil- riers for all enterprises. Improved allocative ity, particularly in rural areas; modernize the Box 1.3 Where are the largest remaining distortions in product and factor markets? In a series of recent papers, Yiping Huang and col- the period 1980–2008 using the input-output panel laborators (Huang 2010; Huang and Tao 2010; of 38 two-digit industrial sectors in China. They Huang and Wang 2010) show that China’s specific find that, on average, factor allocative efficiency reform approach has led to extensive liberalization plays a substantial role in industrial growth by of product markets, with prices of more than 95 per- increasing productivity. Based on their analysis, the cent of products being market determined, but with most urgent reforms are to continue the development continued distortions in factor markets. The authors of factor markets (including by providing nonstate focus on labor, capital, land, resources, and the envi- enterprises equal access to resources and develop- ronment. They present crude estimates of the cost ing nonstate financial institutions) and to deepen the of remaining distortions in each area, with particu- restructuring of state industry. larly high measures for capital and labor. Such dis- Zhang and Tan (2007) examine and estimate tortions acted like implicit subsidies and artificially the changing patterns of distortions during the raised the profits of production, increased returns to reform process. They find that China’s product mar - investment, and increased China’s external competi- kets have become more integrated after an initial tiveness. While such asymmetric liberalization was a period of fragmentation in the early reform period. fundamental cause of China’s extraordinary growth The large shift from farm to nonfarm employment performance, it also contributed to the observed and relaxed constraints on migration also indicate growing structural (including global) imbalances increased labor market integration. However, inter- and risks. Future efforts should focus on comprehen- sectoral differences in marginal product of capital sive market-oriented reform of factor markets. have grown during the reform period, suggesting Similarly, Chen, Jefferson, and Zhang (2011) remaining distortions concentrated in financial and investigate the impact of structural reform during land markets. 88 china 2 0 3 0 institution of the rural collective to remain rural and urban land inu fl ences the structure relevant in the face of evolving shifts in law of government revenues and expenditures. and policy; address the strict separation of Especially during crises, limits of the fiscal rural and urban land tenure systems—which system have encouraged governments (includ- currently drives the inefficiencies and ineq - ing subnational governments more recently) uities generated by the process of convert- to employ the financial sector as a quasi-fiscal ing rural land into urban use—by reducing tool to support state enterprises and pub- the role of state in the land conversion pro- lic and social infrastructure. As a result, the cess and by allowing for more market-based banking system has needed to be periodically allocation of land; ensure the protection of recapitalized, with fiscal repercussions. Thus, priority farmland for food security through making the fiscal system stronger is a critical comprehensive land use planning; and intro- element of making the financial sector more duce taxation of land and property to help competitive and commercial. ease the distortions and social pressures cre- Such reforms must also be carefully ated by subnational governments’ reliance on sequenced. While the following sections pro- revenues from land transfer fees. vide specific suggestions on the sequencing The financial sector faces several reform of reforms within a given area, there also are challenges too. First, there is a need to com- some general lessons for sequencing across mercialize and rationalize the financial broad areas of policy. First, in the most gen- institutions and markets to meet the diverse eral terms, enterprise reforms should precede demands of households, enterprises, and financial sector reforms. Otherwise, a liber - government sectors for financial services alized financial sector channeling resources and products. To this end, financial institu - to a still distorted enterprise sector could in tions should be better governed and operate fact exacerbate distortions in resource allo- in a conducive policy environment and under cation and raise risk levels. In contrast, once competitive pressure and effective regulation major price and other distortions have been and supervision. In addition, there is a need removed, once enterprises have begun to face to further liberalize interest rates, deepen the a truly hardened budget constraint, and once capital market, upgrade financial infrastruc - important sources of moral hazard have been ture and the legal framework, strengthen the addressed, the financial sector will be much regulation and supervision framework, build better placed to allocate capital in line with its a financial safety net and develop crisis man - social rate of return. Of course, that does not agement and insolvency schemes, and recast mean that all financial sector reforms should the rights and responsibilities of government. be delayed. In fact, it places a premium on Supporting Report 4 on social develop- early action to strengthen regulation and ment addresses the issues of improving the supervision, enhance commercialization, and flexibility and efficiency of labor markets in gradually lower floors on lending rates and China, as many of the constraints and issues raise ceilings on deposit rates within a still are interrelated with social protection and controlled setting. insurance. In broad terms, fiscal reform should move While discussed individually here, reforms in tandem with or even slightly in advance of of the fiscal system, the enterprise sector, and enterprise sector reforms. Remaining tax dis- factor allocation are highly interrelated. For tortions and incentives created by the system example, incentives created by the fiscal sys - of intergovernmental finance are combining tem influence the form of industrial policy, with other policies to distort China’s indus- particularly the actions of local authorities. trial structure. Remaining weaknesses in the The differential access to finance of various fiscal system have forced local governments enterprises inu fl ences China’s industrial struc - to rely on off-budget borrowing, further dis- ture. The ability of governments to capture torting resource allocation and raising risk the rents created by China’s dual system of levels. Thus, a front-loading of fiscal reforms, c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 89 particularly in the spheres of revenues (espe- services. The reform also launched impor- cially the channeling of SOE dividends to the tant changes in China’s system of intergov- budget) and local borrowing could create ernmental fiscal relations. Changes in tax conditions for more effective enterprise and assignments significantly strengthened the financial reform. central government’s revenue base, laying the The rest of this chapter examines four spe- foundation for greater and more rules-based cific areas where policy reform will be crucial transfers to begin tackling fiscal disparities. for achieving China’s 2030 vision. In each Further incremental reforms followed in a of these areas, what is the vision for 2030? range of areas. Fiscal policies also played an What progress has already been made, and active role in China’s industrialization. For what are the key current challenges in getting instance, China successfully attracted foreign on a critical path for achieving the vision? investment through preferential tax treat- What more specific steps should be taken ment and other incentives provided by subna- in the near-, medium- and longer term? The tional governments. chapter highlights key points. By 2030, China will need a financially strong and effective fiscal system capable of meeting the economic, social, and environ- Strengthening the Fiscal System mental needs of a complex and sophisticated economy. In particular, as outlined below, Fiscal System Reform in Line with the the government will have to meet increasing Evolving Role of the State demands for public goods and services, an Fiscal policy is a key determinant of efc fi iency expanded social safety net, and improvements and equity and thus of China’s ability to in human capital. Despite China’s substan- achieve its 2030 vision. By efficiently mobiliz - tial existing fiscal space and major untapped ing and spending around 30 percent of GDP, sources of fiscal revenues, the scale of looming government can increase the availability of expenditure pressures combined with the les- crucial public goods and services, address key sons provided by the ongoing sovereign debt externalities, and support increases in overall problems of several developed regions attest efficiency. Tax policies have indirect incen- to the importance and difc fi ulty of maintain - tive effects on the savings, investment, and ing fiscal sustainability. Fiscal costs need to consumption decisions of firms and house - be honestly estimated when initiating new holds. Government also has a central role social programs, and containment of some in reducing inequalities in opportunity and expenditures should be considered. In addi- maintaining macroeconomic and financial tion, fiscal system reform will be a key instru - stability. Well-designed fiscal reform can ment for recalibrating the role of the state and help sustain rapid growth, address important strengthening governance and self-regulation social gaps, and make the development path to meet China’s emerging challenges. Such more environmentally friendly. reforms would focus on provision of public Over the past two decades, China has goods and services, including regulatory insti- greatly reformed its fiscal system. A major tutions, and on providing appropriate incen- overhaul in 1994 focused on enhancing rev- tives for subnational governments to carry enue mobilization and revamping national- out their functions in a financially sustainable provincial fiscal relations. A new tax system and operationally self-disciplined manner. with the value added tax (VAT) as its core Over the next two decades, successful reform laid the foundations for a significant growth and institutional strengthening would funda- in the revenue-to-GDP ratio. This increased mentally transform China’s fiscal system in revenue allowed China’s public spending to v fi e important dimensions: grow to levels comparable with other econ- omies with similar incomes, bringing sig- 1. The composition of spending would be nificant improvements in public goods and different from what it is today, reflecting 90 china 2 0 3 0 changes in the function of government as past improvements in institutional capacity. China attains higher income levels, places Within each of the five priority areas, the greater emphasis on social and environ- report explores policy options and tools that mental outcomes, and faces the need to could be useful for China to manage its new operate and maintain its rapidly growing challenges and contain emerging risks. stock of infrastructure. 2. Most remaining distortions in the rev- China’s Fiscal System: enue system would have been addressed Key Developments to 2010 with a view to improving efficiency and equity, and with several currently minor Government spending has supported the or nonexistent revenue sources (such as country’s development strategy and has carbon taxes, personal income taxes, and evolved in response to changing development SOE dividends) playing significant roles objectives. Expenditures heavily tilted toward in both mobilizing on-budget revenues physical investments supported rapid growth and addressing key distortions. in a “catch-up” phase during which the 3. While public spending may or may not removal of physical bottlenecks offered high play a larger role in the economy than it rates of return. While off-budget investment does today, the relative levels of spending by local governments obscures the size and and revenue would be in line with macro- composition of such investments, total pub- economic stability, balancing the tensions lic spending on infrastructure is estimated arising from pursuing the dual objectives to have reached over 10 percent of GDP (Liu of rapid growth and greater social and 2010), compared with 3–4 percent in many environmental sustainability. other developing countries. More recently, 4. Intergovernmental fiscal arrangements spending has begun to be shifted toward pro- would be better balanced, both vertically moting equity and more balanced growth, in (between levels of government) and hori- line with China’s development strategy out- zontally (across jurisdictions), especially lined in the 11th 5YP. To this end, the gov- at the subprovincial level. This would ernment has expanded its network of social promote the adequate provision of local protection, such as urban and rural minimum infrastructure, social protection, and income support, rural medical cooperative basic public services. schemes, medical assistance for the poor, and 5. A significant strengthening of budget sys - central transfers to expand rural education. tem institutions (including full consoli- It has also increased expenditures on rural dation of spending and revenues) would areas and agriculture, abolished agricultural have greatly enhanced accountability and taxes, significantly narrowed the fiscal dis - transparency, improved budget planning parities across provinces through transfers, and execution at all levels of government, and improved provision of public services. and thus improved the effectiveness of A large share of government spending government. has been devoted to “economic activities,” while gaps in core public services such as This report argues that such a transfor- health and social protection remain signifi - mation can be achieved through a continua- cant. According to the International Mon- tion and deepening of the fiscal reforms that etary Fund (IMF), total general government China has pursued over the past decades. spending reached 25.7 percent of GDP by Past and present policies have been broadly 2008. As table 1.2 shows, China’s public appropriate given the challenges of the spending on social protection and health as time, and much has already been accom- a share of GDP is well below that in OECD plished. However, more remains to be done and upper-middle-income country averages. to complete the reform agenda, to align with If such spending is excluded, the remaining evolving challenges, and to benefit from nonredistributive government spending is c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 91 TABLE 1.2 Size and composition of public expenditures, cross-country comparisons as a share of GDP Percent of GDP High income Middle income Expenditure OECD Upper middle Lower middle China Total outlays 41.6 33.1 36.1 25.7 General public services 5.6 5.6 5.5 2.9 Defense 1.6 1.5 2.2 1.3 Public order and safety 1.6 2.0 2.6 1.3 Economic affairs 4.2 5.3 6.1 7.9 Environment protection 0.7 0.5 0.3 0.5 Housing and community amenities 0.8 1.2 3.0 1.9 Health 6.3 3.3 3.1 1.0 Recreation, culture, and religion 1.2 0.8 1.0 0.5 Education 5.4 3.9 5.4 3.7 Social protection 15.2 9.0 6.9 4.7 Memo: total outlays excluding health and social protection 20.1 20.8 26.2 20.0 Sources: Government Finance Statistics (IMF), World Development Indicators, and World Bank staff estimations. Note: Data are for 2007, except for China, where they are for 2008. China’s social protection includes outlays for both the pension fund and health insurance. The total public expenditure on health financed from the general budget was about 2.5 percent of GDP in 2008. comparable with that in OECD countries. for personal income taxes, and introducing a This imbalance reflects the active role of fuel tax. China’s government in economic activities, Improved revenue collection allowed including subsidies to firms and infrastruc - spending to grow without compromising ture spending. Part of infrastructure spending macroeconomic stability. Headline budget- is financed by revenues from the sale of land ary revenues have increased from less than 10 use rights that are (correctly) excluded from percent of GDP in the mid-1990s to around the aggregates noted above but now subject 20 percent of GDP today. The government to budgetary oversight. However, a more also raises some 2 percent of GDP through significant amount of investment is funded “government funds” other than land revenue through borrowing by local Urban Devel- and about 4 percent of GDP through social opment Investment Corporations (UDICs), protection contributions. In addition, subna- whose activities are off budget by definition. tional governments raise significant revenues Adding their expenditures would raise the from land assets and borrowing through total public spending in 2008 to around 30 UDICs, which have mainly been used to sup- percent of GDP. While an active govern- port land development and infrastructure ment role in resource allocation is appropri- investment. The resulting modest fiscal ate in the catch-up phase of development, this deficits and reported government debts also role should shift toward the core business of allowed the government to effectively cush- government—provision of public goods and ion the negative shock from the recent global services—as China enters a more advanced financial crisis. stage of development. The recentralization of revenues in 1994 On the revenue side, a series of reforms strengthened the central government’s capac- have addressed many past distortions. These ity to redistribute in favor of poorer prov- reforms include unifying the corporate inces. Net transfers from the center make income tax (between domestic and foreign- up an increasing share of subnational gov- funded enterprises), shifting from a produc- ernment resources (table 1.3). Among trans- tion-based to a consumption-based VAT, fers, both general equalization grants and lowering import tariffs, raising the threshold earmarked transfers (targeted at specific 92 china 2 0 3 0 TABLE 1.3 Subnational government finance 1996 2001 2008 2009 Item yuan (billions) % yuan (billions) % yuan (billions) % yuan (billions) % Budgetary expenditures 578.6 100 1,313.5 100 4,924.8 100 6,104.4 100 Budetary revenues 374.7 64.8 780.3 59.4 2,865.0 58.2 3,260.3 53.4 Net transfer from center 211.9 36.6 541.1 41.2 2,204.4 44.8 2,856.4 46.8 Of which: General transfer 15.9 2.7 121.5 9.3 874.6 17.8 1,131.7 18.5 Earmarked transfer 48.9 8.5 223.7 17.0 996.7 20.2 1,236.0 20.2 Sources: Ministry of Finance and staff calculations. development priorities) have been growing Challenges and Policy o ptions for in recent years, allowing a welcome phased Strengthening China’s Fiscal System reduction of the “transitional systems trans- The long-term vision and current starting fer.” Viewed at the provincial level, such point elaborated above imply a clear direction transfers have vastly reduced, if not removed, for fiscal reforms over the next two decades. the correlation between government expendi- In most aspects, the broad direction is under- ture per capita and the level of local economic stood by policy makers, and related programs development. The difference in expenditure have been included in the 12th 5YP. Within per capita across provinces can be largely each of the five noted dimensions, this sec - explained by factors that affect the delivery tion highlights more specific areas that offer cost, including average wage and population the greatest challenges as China seeks to get density. on a path to achieving its vision. Drawing on Finally, the efficiency of public expen- international benchmarking and experiences, ditures has been improved through a range it also suggests policy options and tools that of measures to strengthen public financial could be applied in China. management. Most extrabudgetary charges have been abolished or brought on budget, Restructuring government expenditures. The and plans are in place to bring the remainder composition of government spending needs on budget. As in many countries, although to evolve to reflect China’s changing devel - social security contributions and revenues opment challenges as it transitions to high- from sale of land use rights and other govern- income status. Most notably, providing social ment assets flow to separate funds, they have security and a basic set of public services, all been subject to budget-type management, and building human capital and expanding and a more comprehensive view of public opportunity will require additional spend- finances is emerging. Dividends from SOEs ing on health, social protection, and envi- have begun to grow, have been brought into ronmental protection. As shown in table 1.2, a separate capital operating budget, and are China’s public spending on social protection gradually becoming available to finance the and health as a share of GDP is significantly general budget. Single treasury accounts have below average levels in OECD and upper- been broadly established at the central and middle-income countries. The gap in educa- provincial levels and are being rolled out at tion spending is quite a bit smaller. While lower government levels, laying the basis for enhanced monitoring and control of budget China’s reported spending on environmental execution. Government accounting reform protection appears in line with OECD and with improved classification of govern- upper-middle-income country norms, the sig- ment activities made a strong foundation for nificant backlog and new challenges in this improving transparency. Performance evalu- area could well require a further scaling up of ation has been piloted in selected programs. such expenditures. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 93 FIGURE 1.1 Cross-country comparison of government expenditures as a share of GDP b. Environment protection a. Education Iceland Japan Sweden United Kingdom Denmark France United States Italy United Kingdom Canada Canada Iceland France Belgium Belgium Norway Finland Switzerland Switzerland Australia Norway Greece Austria Denmark Australia Germany Italy Austria Germany Sweden Japan Finland Greece China China Russian Federation Russian Federation 0 2468 0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 % of GDP % of GDP c. Health d. Social protection Denmark Iceland France France United States Sweden Austria Finland Canada Germany Denmark Austria United Kingdom Greece Japan Italy Norway Belgium Belgium Norway Italy United Kingdom Sweden Switzerland Finland Japan Australia Canada Germany Australia Greece Iceland Switzerland United States China China Russian Federation Russian Federation 0246 80 5101520 25 % of GDP % of GDP Source: Government Finance Statistics IMF 2007, 2009, and staff estimation. There is no uniform high-income-country Iceland, and the share of social protection model for the size of such expenditures rela- ranges from 7 percent in the United States tive to GDP, especially for social and envi- to over 20 percent in Denmark and France. ronmental protection. High-income countries The overall cost depends greatly on the level tend to spend more on these items than of protection and the scheme design, which middle-income countries, but with much is ultimately a political decision of the coun- variability. Figure 1.1 benchmarks China’s try. Also, given the fiscal problems currently spending on these four items against a range faced by many advanced economies, their of high-income countries and the Russian current spending levels should not be com- Federation. For example, the share of pub- pared very mechanistically. lic spending on health in GDP ranges from Using these and other international bench- 4.1 percent in Switzerland to 7.9 percent in marks as reference, China could potentially 94 china 2 0 3 0 aim to increase public expenditures by 2–3 this role has evolved significantly over the percentage points of GDP for health care, past 30 years and should continue to do so. 1–1.5 percentage points for education, and Once this has been decided, practical adjust- another 3– 4 percentage points to fully ments to current spending patterns need to be finance the basic pension pillar and to gradu - agreed and implemented, taking into account ally meet the legacy costs of existing pension China’s specific organizational arrangements. obligations. These add up to an incremental One way to begin this process is through the fiscal outlay of around 7–8 percent of GDP— use of functional reviews (box 1.4). which is a reasonable estimate to bring Chi- na’s aggregate “social expenditures” by 2030 Further reform of taxes and other revenue to near the lower end of the range of high- sources. To achieve its 2030 vision, China income countries. Going forward, China will will need to adjust its revenue policies to gen- also need to allocate more resources to oper- erate adequate on-budget revenues to cover ating and maintaining its rapidly growing expenditures, cut efficiency-reducing distor - stock of physical infrastructure assets. tions, and promote social and environmental While infrastructure investment may need objectives. The main challenges and opportu- to be scaled back in the longer term, these nities are focused in three main areas. and other expenditure reallocations need not First, China has significant untapped be linear. In the short to medium term, still potential to introduce or expand revenue rapid urbanization and further integration sources that simultaneously promote all three of the national market could demand more of the noted objectives. These are concen- infrastructure investment. The further rise trated in four areas, two at the national level, in household income would correspondingly and two at the subnational level. The most increase the financial and economic return to significant near-term source of additional infrastructure, justifying such investments. revenues is the collection of higher levels Over the medium to long term, as the infra- of SOE dividends and their full channeling structure stock is built, the marginal rate of to the budget. This adjustment could spur return to infrastructure assets could begin to more efficient investment planning in SOEs decline. By that time, public investment could while also generating significant resources. be more rapidly phased down toward levels For example, were SOEs to pay out half of observed in higher-income countries, leaving their profits to the budget—a ratio prevail - more resources for other activities. ing in developed countries—budgetary rev- The structure of public investment also enues would grow. In the near to medium needs to evolve to meet emerging needs. The term, higher taxes or prices on energy (car- challenge is to choose projects that address bon), water, natural resources, and pollu- current bottlenecks. As China develops, the tion would encourage their more efficient bottlenecks are also changing. From a spatial use while improving environmental out- perspective, no economy will develop equally, comes and generating major revenues. For and cities are more likely to be the poles of example, Stern (2011) estimates that a tax growth (World Bank 2009d). For China, Luo on coal at fairly modest carbon prices (for (2005) finds that infrastructure investments example, $20 a metric ton of carbon dioxide) in some inland regions such as Hubei and could yield revenues equivalent to 2–3 per- Sichuan could reduce the regional develop- cent of GDP. In addition, enhanced taxation ment gap without sacrificing much growth. of motor vehicle use and charges on parking Therefore, from the perspective of enhancing (as a near-term option) and congestion (as a growth, more public investment could be spa- longer-term option) would lead to more effi - tially targeted to cities and selected regions. cient and livable cities and better environ- In any case, the government needs to rede- mental outcomes. Experience with motor fine its role and restructure its expenditures vehicle taxes, piloted in Shanghai, and with in line with its development goals. In China, congestion charges, such as in Singapore and c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 95 Box 1.4 Functional reviews: A tool for designing reforms for a more efficient government Functional reviews offer a flexible, problem-driven, resulted in a 50 percent downsizing of the public and evidence-based framework that can help public sector. In Latvia, a 1999 functional review of the sector organizations at various levels to identify key Ministry of Agriculture identified 161 separate func - performance constraints, analyze the functions they tions, of which 9 were identified for privatization, 40 perform, assess their relevance, and draw recom- for rationalization, and 12 for transfer to other sec- mendations for organizational and process changes tors. Implementation closely followed the proposed to enable more effective delivery. These reviews typi- review. cally evaluate existing expenditure programs along The literature on functional reviews points to key two dimensions: efficiency and effectiveness. Each success factors. First, such exercises involve setting review varies by objectives and scope. In some cases, general targets, but without specifying where they the focus is at the policy and program level on effec- will be found. Second, aligning functional reviews tiveness concerns; in other cases, the focus is at the with the budget process is essential to ensure that organizational level on efficiency concerns or a com - recommendations are provided at the appropriate bination thereof. point in the budget cycle. Third, one reason for suc- Functional reviews have been applied in many cessful reviews in high-income countries was that countries. In Canada, a 1994 program review estab- the legal mandates of the agencies and programs lished a high-level special committee under the were flexible enough to allow relevant ministries to prime minister. The committee set performance- amend their own structure and services. Fourth, it based guidelines and managed the review process is often difficult for such exercises to succeed in the that helped to generate substantial cuts (averaging absence of strong political leadership or of owner- 21.5 percent across departmental budgets). In New ship and buy-in on the part of line ministries and Zealand, an expert-based, top-down review of the departments. Finally, a compelling need for such state sector was undertaken without the participa- reviews, such as a looming fiscal crisis, can help gain tion of line agencies. Restructuring in many sectors the consent of the public. Source: World Bank 2009b. London, could offer useful guidance. Finally, FIGURE 1.2 Cross-country comparison of tax rates as elaborated in greater detail in the subse- quent discussion of land policy, expansion of Value added tax rate, % property taxes to residences would encour- age more efficient use of land and also reduce 50 urban sprawl. While promising, it will take time before property taxes become a major Tax Corporate source of overall revenues—very few devel- wedge, income as % of 10 tax rate, % oping countries raise more than 1 percent of gross GDP from this source (Bahl 2009). salary Second, reform of labor taxes can promote both greater efficiency and reduced imbal- ances. Figure 1.2 gives a comparative picture of the main tax rates on goods and services, Social contribution Highest marginal rate, % income tax rate, % corporate income, and labor income. The fig - ure shows that while China’s taxes on goods China Western Europe East Asia and Paci�c Latin America and corporate income are not out of line with Western European and Latin American averages, its marginal rates of labor taxation Source: Fiscal Reform and Economic Governance 2011. 96 china 2 0 3 0 FIGURE 1.3 Cross-country comparison of government revenue progressive (discouraging the formation of human capital), while the various social con- tributions are high and regressive, adding Norway 34.6 9.1 14.9 further distortions and encouraging evasion Denmark 47.8 1.9 6.1 at both ends of the income spectrum. As a Sweden 35.2 12.6 7.5 combined effect of still low levels of cover- Finland 30.8 12.0 9.8 age, a narrow base, and high levels of in-kind France 26.7 18.0 4.9 Belgium 29.7 15.7 2.7 compensation and informal employment, Austria 27.5 15.8 4.6 China also collects relatively little from social Iceland 37.5 3.0 7.2 security contributions despite their high rates Italy 29.8 13.3 3.3 (figure 1.3). Germany 23.8 16.4 3.5 A phased approach is advisable to reform United Kingdom 29.5 8.3 3.7 the labor taxation. In the near term, the con- Canada 28.9 4.6 7.6 Greece 20.3 14.0 6.0 tribution rate for unemployment insurance Switzerland 22.2 6.7 7.9 could safely be reduced by around 1 percent- 29.3 0.0 6.4 Australia age point. In the medium term, the personal United States 21.3 6.9 5.8 income tax could be consolidated to cover Japan 18.3 11.1 3.9 incomes from all sources (including capital Korea, Rep. 21.0 3.4 6.2 Singapore 13.1 0.0 6.6 gains), its base expanded by scaling back cur- China 18.6 3.4 4.6 rently significant exemptions, and simplified Russian Federation 27.0 6.0 14.5 with a lower marginal tax rate. If the first two effects were to dominate, and to be sup- % of GDP ported by an enhanced collection effort, such Total tax Social contributions Other revenue a reform could possibly raise personal income tax revenues by around 1 percent of GDP in Sources: Government Finance Statistics IMF 2007, 2009, and staff estimations. the medium term and 2 percent of GDP or more in the more distant future. In the lon- ger term, China’s social protection contribu- are far above global norms. Its top marginal tions could be reformed through reductions rate for personal income tax (45 percent), in average rates combined with efforts to total pension contribution rate (28 percent address the regressivity introduced through of average salary of formal employment), high minimum contributions, complemented and the overall labor tax wedge are high by by other reforms to mitigate unintended any standard. These high rates work to effects on the finances of the respective social reduce formal demand for labor and keep the funds. The latter could include separating out wage share in GDP low, promoting inequal- the “legacy costs” of the pension system and ity and discouraging consumption. Despite funding these from general revenues. these high rates, major exemptions at lower Third, the taxation of land will need to income levels mean that China mobilizes sur- shift away from transaction-related revenues prisingly little from personal income taxes. toward a modern property tax. As elaborated Data from the U.S. Agency for International in more detail later in this chapter, China’s Development (Fiscal Reform and Economic subnational governments derive substantial Governance 2011) indicates that China raises revenues from the sale of land use rights and around 1 percent of GDP from personal taxes on real estate transactions. Because income taxes, against an average of 5.85 per- prices and trading volumes in the property cent in high-income countries. The personal market can be highly volatile, such revenues income tax is also based on different rates for may not be reliable for financing essential different types of income, introducing further public services and may put fiscal sustain- distortions and inequities. At incomes beyond ability at risk. In addition, distorted incen- the basic exemption, the tax becomes highly tives for officials in land development lead to c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 97 inefficient use of land, corruption, and abuse further growth of real revenues and favor- of government power in land acquisition. able debt dynamics. China’s government Since changes in land compensation practices commands a large portion of assets includ- will in any case lower the net resources that ing SOE shares and land, which represent subnational governments can derive from a source of potential revenues going for- such sources, these governments will need to ward. Large national savings coupled with find new revenues to fund their operations. investment-grade sovereign risk ratings imply As detailed below, expanding property tax to a relatively low cost of borrowing. Given cover residences offers such potential in the these factors, China could in principle sustain longer term. somewhat higher annual fiscal deficits in the Other important reforms on the revenue range of 3–4 percent of GDP. side would include further changes in the At the same time, significant new pres- VAT, enterprise income tax, and consump- sures will challenge China in maintaining tion tax. These reforms could help rebal- fiscal stability. Citizens’ growing emphasis ancing—making growth more domestically on social and environmental outcomes, rapid driven and services driven. Changing the population aging, and further urbanization excise tax on services to a value added tax will put upward pressure on public spend- would not only lower the tax burden but ing. As noted, the combined effect of raising also improve services’ competitiveness and social expenditures toward levels observed at promote specialization. China’s current the lower end of the high-income spectrum residence-based enterprise taxes deprive poor could alone add around 7–8 percent of GDP provinces of significant revenues because to total spending. In the absence of reduc- company headquarters are usually located tions in the share of other spending items in in richer provinces. These taxes also have GDP, China’s total fiscal expenditure would encouraged wasteful tax competition and reach around 40 percent of GDP. As shown beggar-thy-neighbor policies among subna- by the current sovereign debt crises in some tional governments. In the medium term, high-income countries, the revenue collec- while the collection of the VAT, enterprise tion efforts required to finance such a level income tax, and consumption tax could of spending could either be inconsistent with remain residence based, the income could be rapid growth or (if patently infeasible) with attributed to various locations, based on the macroeconomic stability. The conversion of headcount of registered household, consump- currently quasi-fiscal liabilities (of UDICs, tion, or value added (Xu 2006). for example) into explicit public debt could add further fiscal pressure. At the same time, Maintaining fiscal sustainability. Past fiscal slowing economic growth will cut the poten- reforms and prudent macroeconomic policies tial growth rate of total fiscal revenues below have left China with significant fiscal space. past levels, while the government faces pres- Over the past decade, fiscal balances have sure to cut taxes to boost household dispos- ranged from small surpluses to small deficits able income and facilitate restructuring. (a 1.6 percent deficit of GDP in 2010). While Meeting the triple challenge of maintain- off-budget borrowing by subnational authori- ing fiscal stability, sustaining rapid growth, ties complicates the measurement of overall and addressing social and environmental public debt, a conservative estimate of the imbalances will require choices in the face debt of subnational governments based on a of difficult trade-offs. Even among high- recent report by the National Audit Office income countries, different countries handle would put overall public debt at around 44 such pressures in different ways, in line with percent of GDP by the end of 2010. their specific circumstances and preferences. Several factors will work to preserve or If China does not want to grow its size of even enhance this fiscal space. China’s large government to average levels in high-income growth potential creates the foundation for countries, part of the adjustment will need 98 china 2 0 3 0 to come from containment of some expen- thus supporting industrialization and urban- ditures. In the near term, that could include ization. Debt financing will remain impor - cuts to capital transfers and other enterprise tant for China’s urbanization drive, which subsidies, streamlining government institu- demands continuing large investments in tions and employment, and regulating “on- urban transit including subways, power, the-job consumption” (san gong xiao fei in water, sewage, and the like. However, lim- Chinese). Over time, as China’s front-loaded ited transparency and regulation has created public investment program achieves its ini- potential risks to fiscal sustainability and the tial aims, such investment could begin to quality of bank assets. Formally, borrow- be scaled back. Given China’s fiscal space ing through UDICs should be for revenue- and the existence of major untapped rev- generating purposes that can pay back the enue sources, a large part can come from loan. In reality, a part of such borrowing the scaling up of several taxes (noted above). appears to be for other purposes. Such quasi- Such trade-offs will be eased by reforms to fiscal financing also obscures the true size enhance the efficiency of government, includ - and composition of public spending and rev- ing through the functional reviews described enues. The lack of a unified planning, execu - above. tion, and monitoring of public spending can China could construct a macrofiscal also lead to inefficient and suboptimal alloca - framework (usually comprising medium-term tion of public funds. budget plans and dynamic debt sustainability Allowing subnational governments to analysis), linked to the five-year development access the financial market could have plan, as a specific tool for promoting fiscal important benefits. Matching the economic sustainability. Such a tool, employed at both life of assets that the debt is financing with national and local levels, would help ensure the maturity of debt is sound public policy the consistency of public spending with the because these infrastructure services can country’s development strategy and resource and should be paid for by the beneficiaries envelope. First, it would reveal the implica- of the financed services. Market access and tions of current decisions on taxation and the operation of an active secondary market spending on future budgetary and financing expose subnational governments to market needs. Second, it can expose the fiscal risks disciplines and reporting requirements, help- emanating from various sources such as ing to strengthen fiscal transparency, budget contingent liabilities being called and global and financial management, and governance. shocks hitting output growth. Third, it can A competitive subnational credit market help evaluate the government’s capacity to with numerous buyers, sellers, and financial meet current and future financial obligations. options, such as bonds that compete with Were such analysis to show that debt limits loans, can help diversify financial markets are likely to be breached over the projection and lower borrowing cost. horizon, the government’s plans would need Moving forward, the central government to be revised accordingly. needs to establish an institutional and regu- Fiscal sustainability would also be pro- latory framework to reap the benefits while moted by bringing subnational government mitigating the risks of subnational borrow- borrowing on budget. Currently, while such ing. As demonstrated by over 200 years of governments can formally borrow only with subnational infrastructure financing in the State Council approval, they circumvent this United States, subnational debt financing is limit by borrowing through UDICs and other viable under sound regulatory frameworks. vehicles. Total subnational government debt The government’s recent inventory of all has reached 26 percent of GDP according subnational government borrowings is an to the National Audit Office. Such indirect important first step toward transparency borrowing played a key role in financing in quantifying the liabilities of subnational important infrastructure investments and governments and their entities and lays a c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 99 good foundation for further steps. Box 1.5, weaker localities could initially rely more based on Liu (2010) and Liu and Pradelli heavily on transfers, with the central govern- (2011), provides indicative elements of a ment establishing clear rules about when a regulatory framework for subnational debt subnational government can graduate from management. one status to another. Preconditions for Direct borrowing by subnational govern- UDIC borrowing would include corporate ments could be phased in, beginning with governance reform and clarity in its finan - authorities with the greatest revenue capacity cial relationship with the subnational gov- and most reformed fiscal systems. Financially ernment. Credit ratings and disclosure of Box 1.5 Indicative regulatory framework for subnational government debt Core components of a subnational government debt system can be developed to include debt restructur- regulatory framework are ex ante regulation and ing rules and a priority structure for settling claims. an ex post insolvency system. In China, a complete regulatory framework would also include strict reg- Regulating UDICs. As part of ex ante regulations, ulation on borrowing by Urban Development Invest- UDIC long-term borrowing must be restricted to ment Corporations (UDICs). public capital investments, ratios of operating reve- nues to debt service must be established, and pledges Ex ante regulation. The framework would spell out of assets as collateral must be regulated. Subnational ex ante rules governing the purposes of subnational government guarantees of UDIC borrowing can play government borrowing (such as long-term borrow- a useful role but would follow prescribed rules; for ing for public capital investments only), types of debt example, total guarantees provided must be below a allowed and disallowed (prohibiting exotic financial percentage of the subnational’s revenues, and no sin- products, for example), and procedures for issuing gle UDIC borrower could have guarantees exceeding debt. Fiscal targets can be established quickly by a certain percentage of total guarantees by a subna- focusing on the debt service ratio, balanced operat- tional government. The U.S. regulation for subna- ing budget, and guarantee limits, while developing tional special purpose vehicles can provide a useful thres holds for fiscal sustainability assessment would reference. take more time and effort. Fiscal transparency would To “ringfence” and reduce fiscal risks, China be a precondition for subnational governments and could develop regulatory frameworks for UDICs to UDICs to access capital markets. Credit assessment issue revenue bonds. In contrast to general obliga- by reputable rating agencies can be required of all tion bonds, revenue bonds are secured by the rev- subnational government and UDICS wishing to enue stream generated by the project that the debt is access the capital markets. Only those governments to finance. Revenue bonds reinforce self-sustaining that have adopted fiscal transparency and budgetary finance and allow the market to play a central role in reforms would be allowed access the markets. enforcing debt limitation, pricing risks, and match- ing the maturities of liabilities with the economic Ex post insolvency system. International experi- life of assets. In the United States, revenue bonds ences have demonstrated that unconditional bailouts account for about two-thirds of the US$3 trillion of subnational governments and their entities lead subnational debt outstanding. to moral hazard, encouraging irresponsible fiscal Developing revenue bonds can be supported by behavior and reckless lending by creditors. In the complementary reforms, including corporate gov- near term, China can develop two sets of monitor- ernance reform, regulatory frameworks for setting ing indicators: one measuring fiscal deterioration tariffs, and standardized reporting, audit, and mar- and another one for fiscal insolvency. The key is to ket disclosure requirements. Financial strength is monitor, and intervene early, to prevent subnational assessed through a credit rating system that assesses governments from deteriorating into insolvency. a borrower’s ability to pay debt. Hard budget con- Over the longer term, a more systematic insolvency straints on special purpose vehicles are a must. 100 china 2 0 3 0 audited financial accounts (for UDICs) and where reforms have already been introduced fiscal accounts (for subnational governments) have witnessed improved revenue capac- are prerequisites for borrowing from the ity with increased transfer directly from financial market. Those subnational govern - the province (circumventing the municipal ments and UDICs that are allowed to borrow level—a tier between province and county) should be subject to hard budget constraints, and enhanced monitoring of county finances without recourse to central government sup- by provincial governments. Moving forward, port. It is important for the central govern- a natural step would be to gradually expand ment to send a credible “no-bailout” message this reform to the whole nation. While inter- to the market, one documented in legislation national experience provides limited clues, and demonstrated in action. China’s own pilot programs suggest it has strengthened the fiscal capacity of county Further reforming the intergovernmental governments, reduced the overall cost of gov- relationship. Achieving a harmonious high- ernment, and improved the delivery of public income society by 2030 will require further goods and services. Implementation of such complex reforms of China’s system of local reforms should pay due attention to avoiding finance and intergovernmental fiscal rela - gaps in, or shocks to, service delivery in the tions. The key challenges for China’s fiscal transition period. system in supporting this agenda remain Second, to enhance efficiency and equity high fiscal inequality and a decentralization and to strengthen the national market inte- of many functions that are usually financed gration, some expenditure responsibilities or provided by higher levels of government in or their financing could be raised to higher most high-income countries. Reforms in four levels of government. The economic literature areas stand out: completing the move from prescribes that a function should be assigned v fi e to three levels of government; selectively to the level of government that best matches raising some functions to higher levels of gov- benefits and costs of that function, whereas ernment; introducing some more formal cen- the “subsidiarity principle” would lead to tral government involvement in subprovincial assignment of a function to the lowest pos- distribution; and introducing new sources of sible level (Dollar and Hofman 2006). These subnational own revenues. considerations still leave much scope for First, the ongoing move from five to three interpretation. In practice, there is consider- (budgetary) levels of government should be able variety among countries in the assign- completed. This is a key step toward stream- ment of functions. As table 1.4 shows, China lining the size of government, improving is much more decentralized than high- and the efficiency of government services, and middle-income countries on the spending empowering county governments. Such side. In several cases, China’s assignment of reforms in the fiscal management system are functions is out of line with theory and global already being introduced in 27 provinces, good practice. In most countries, income- covering more than 900 counties (Ministry maintenance responsibility (pensions, disabil- of Finance 2010). Most county governments ity, and unemployment insurance) is the task TABLE 1.4 Share of subprovincial governments in total government revenues and spending Percent Share provided by High- subprovincial Developing income Transition governments countries countries countries China Tax revenues 9.3 19.1 16.6 34.2 Government expenditure 13.8 32.4 26.1 59.3 Sources: Dollar and Hofman 2006; staff calculations. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 101 of the central government, for the good rea- ultra vires definition of subnational govern - son that centralization can help pool the risks ments). But even if subnational government is across regions and encourage labor mobility granted a wide range of autonomy (“general and participation. In China, this also has competence”), the central government could an equalization effect, because some coastal consider specifying at least those functions provinces have relatively high employment- that it must perform. to-retiree ratios thanks to many migrant A second option would be for the cen- workers. tral government to get involved in the sub- Third, China could consider introduc- provincial distribution of resources. For ing more formal direct central government example, the center could, as a minimum, involvement in subprovincial fiscal rela- establish expenditure needs for each level tions. Because the tax-sharing arrangements of government and set limits on the dispari- introduced in 1994 were not extended to the ties among subprovincial governments. Once subprovincial level, the most serious fiscal dis - the assignment of expenditure responsibility parities remain at that level, which accounts to subnational governments is decided, rev- for nearly 60 percent of total public spending. enues would be assigned to ensure adequate In 2007, provincial governments on average resources to perform these tasks. In this pro- took about 25 percent of total subnational cess, the center could mandate some degree revenue, municipal governments a further of uniformity in subprovincial revenue one-third, and county governments, which assignment and transfer. One very ambitious provide most services, took the remaining 41 option would require the provinces to trans- percent. Subprovincial fiscal arrangements fer revenues to the county level in the same remain at the discretion of provincial govern- way that transfers are allocated to the prov- ments, leading to high variation across prov- inces. Alternatively, the center could require inces. For example, the share of provincial the provincial governments to achieve cer- governments in subnational revenues ranged tain prescribed targets, such as a minimum from 37 percent in Gansu to only 9 percent level of education expenditure per student, in Henan, while the county governments’ and revenue capacity equalization at some share ranged from 30 percent in Helongjiang level. to over 68 percent in Zhejiang. In general, There also is further scope beyond the the higher-level government grabbed a higher property taxes already noted for subnational fraction of fiscal revenue than its share of governments to tap new sources of “own” expenditure responsibilities. As a result, the revenue. The high disparity in development most serious vertical and horizontal imbal- warrants some flexibility in revenue assign - ances are at the lower levels of government ment. China could consider first granting (counties and below). new sources of own revenues to subnational One option for addressing subprovincial governments in relatively developed cities. disparities would be to set some limits on This step would free up fiscal resources for the expenditure autonomy of subnational more transfers to poorer regions, and help governments. Any such solutions would be bring a larger share of subnational financ- guided by (and possibly limited by) a clear ing on budget. It might also help reorient the understanding of the specific role of sub- enthusiasm of subnational governments from national government in China. As in other growth and investments to a more balanced unitary countries, while local authorities growth strategy that reduces rural-urban dis- are in principle agents of the central govern- parities (discussed in more detail in the sec- ment, they still enjoy a high degree of auton- tion on land policy). Finally, it could improve omy. In many cases, the central government accountability, because citizens will hold determines by law what types of activi- officials more accountable if local public ser - ties subnational governments can engage vices are financed to a significant extent from in through a positive list of functions (an locally imposed taxes. 102 china 2 0 3 0 A good local tax should meet several cri- transparency in fiscal and intergovernmental teria. The subnational government should fiscal matters in law. be able to set the rates itself, at least within Despite past improvements, China still limits. The tax should be visible to local tax- faces considerable challenges in enforcing payers, large enough to finance a chunk of accountability. The lack of accountability local services, and not easily exported out- reduces what the intergovernmental fiscal side the jurisdiction. In addition to the prop- system can achieve in terms of efficiency erty taxes and motor vehicle and congestion and redistribution. Given the high degree charges noted earlier, own revenues could of decentralization in China, a key issue is also include a local personal income tax, pos- accountability of local authorities to the cen- sibly as an add-on to the central government tral government. Specifically, with limited personal income tax rate. However, because accountability for results, more equalization the top national tax rate of 45 percent leaves of spending to poorer provinces could well little space for such an addition, reform to lead to waste of resources rather than bet- cut the top marginal rate may be crucial for ter service delivery for the poorer part of the meaningful progress on granting subnational population. To enhance accountability of governments more flexibility to raise own subnational governments, the central gov- revenues. ernment could consider the following four measures: Institutional reform to enhance accountabil- ity and transparency at all levels. Improved 1. Periodic evaluation of the fiscal implica - information and greater fiscal transparency tions of expenditure assignments. Dispar- at all levels of government would bring many ities among regions, the quality of basic benefits. These include greater efficiency, infrastructure, priority areas for invest- reduced corruption, and improved cred- ment, and the technical capacities of sub- itworthiness. Past reforms of government national governments can all change over accounting classifications, and the construc - time. The central government must have tion of capital operating budgets and social flexibility to adjust to such changes. Such fund budgets, have laid a good foundation evaluation will need to bring out the fis - for improving government self-regulation. A cal implications (and necessary remedial natural near-term step would be to further the policies) for the next 5 to 10 years if any reforms to make information accessible to tax- restructuring takes place. This is a bigger payers, research institutes, and universities. issue than just expenditure assignment. More information in the public domain would The financing of this shift in responsibil - allow better policy analysis and evaluation ity would likely include a reassignment of and expand citizens’ scope for active partici- some revenue sources and reallocation of pation in policy debate. That, in turn, would transfers as well. ultimately lead to wider acceptance of policy 2. Development of a medium-term fiscal choices and enhanced government credibility. framework and system for monitoring Possible medium- and long-term measures the fiscal development of subnational include better aligning of budget formulation governments. Local officials in China and execution, moving the budget calendar have inherent biases favoring the alloca- to better reflect the schedule of the National tion of resources to physical investments People’s Congress, changing from cash to and “leaping forward.” These can lead to accrual accounting, producing an inventory excessive (hidden) expansion of govern- of government financial and physical assets, ment debt, and fiscal stress in the medium and eventually constructing the government’s and long run. One way to mitigate such balance sheet. The upcoming revision of the risks is to require subnational government budget law is an opportunity to anchor more to develop a medium-term fiscal plan and c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 103 undertake the assessment of debt dynam- Enterprise Sector Reforms ics. Through this process, the fiscal impli - The Enterprise Sector and China’s Vision cations of any reform can be calibrated for 2030 and public expenditure and revenue deci- sions integrally articulated. A vibrant and increasingly efficient enterprise 3. Comprehensive evaluation of the perfor- sector is key for sustaining relatively rapid mance of local officials. Until recently, growth and enhancing the innovativeness evaluation criteria for local officials were and global competitiveness of China’s firms heavily focused on GDP growth. That over the next two decades. It would support growth is not hard to measure, and the growth by promoting further productivity accountability system has worked reason- gains and by keeping returns to capital at ably well. But the shift in focus to a “har- levels that sustain high investment demand. monious society” requires a greater focus Combined with a more favorable environ- on outcomes such as the health status of ment for small and medium enterprises the population, educational attainment, (SMEs), service sector firms, and labor inten - energy efficiency, and environmental sive firms, it would also promote China’s quality. As these mandates are spread objectives of moving to a more innovative among line ministries, it will inevitably and harmonious society. be harder for the central government to Successful reform and the resulting struc- know if the local government is doing a tural change would leave China with a very good job meeting these multiple objec- different enterprise sector by 2030. In nearly tives and to use that information in staff- all industries, a range of firms with diverse ing and financing decisions. size and ownership would compete vigor- 4. Cross regional and sectoral coordination. ously on a level playing field, facing similar China has quite a few revenue transfers: market-driven factor and input prices. Many some are allocated among regions, and sectors would have been greatly consolidated, others are earmarked for specific issues: primarily by market forces. Entry barriers for example, transfers for rural education. could remain in a few “natural monopoly” Each transfer program is administered sectors where dominant providers (whether separately and often allocated in an ad state owned or private) are subject to effec- hoc manner. It is important to ensure that tive regulation. Large firms, including a the different transfer programs combine diminished number of SOEs, would feature to provide solid foundations for regional modern corporate governance with profes- development, and to ensure equity across sional boards deciding key strategic mat- regions and consistency with the national ters. Having been made more competitive development strategy. by vigorous competition from home and abroad, Chinese firms would be increas- One bold option for enhancing subna- ingly successful in global markets. Within tional government accountability in public government, the functions of policy making, services would be to establish a budget com- regulation, and supervision would be better mittee under the direct oversight of the State separated, each led by a single agency with Council, and to centralize the performance strong capacity, clear mandates, and account- evaluation and monitoring of local agen- ability. Finally, “industrial policy” may still cies (including the noted four functions) in be implemented, but in a more focused, con- a single ministry. Such a practice is adopted sistent, predictable, and market-friendly way in many countries including Japan and Fin- than it is today. land, either as a separate ministry or as part Going forward, China will need to deter- of an existing ministry, such as the Ministry mine the relative role of the state in rela- of Finance. tion to the market and the private sector in 104 china 2 0 3 0 FIGURE 1.4 So Es have declined in relative economic activity. While a large state role importance may have had beneficial effects during the recent crisis, China’s own experience over a longer period supports its further scaling back. As elaborated below, China’s nonstate enterprise sector is much more productive, profitable, and innovative than its SOE sec - tor. Much of China’s impressive productivity growth over the past decade was driven by manufacturing, which had just been opened to greater competition. To sustain rapid GDP growth, China will need to extract more pro- ductivity from its currently protected services 1998 2000 2002 2004 2006 2008 2010 and utilities sectors. One way to achieve this SOE share of total industrial enterprises SOE share of total industrial assets is through the same model that worked so SOE share of total industrial employment well for manufacturing: expose firms to com - petition through deregulation, international Source: National Bureau of Statistics (China), various years. trade, and private participation. In addi- tion, the relationships between government and enterprises need to be reformed to allow of technological innovations came from the firms with different ownership and sizes to nonstate sector. have equitable access to resources and busi- The 9th 5YP’s guiding principle of “grasp- ness opportunities. ing the big, letting go of the small” left China with a distinctive industrial structure. Most small and medium-size firms became pri- China’s Enterprise Sector: vately owned. Facing much domestic and Key Developments to 2010 external competition in an increasingly inte- Significant enterprise sector reforms have grated domestic market, they became very underpinned China’s successful past growth dynamic and productive and now dominate performance. In particular, bold reforms many sectors. In parallel, the “command- under the 9th Five Year Plan 1995–2000 led ing heights” of the economy (most notably to a greatly expanded role for the private and the 120 or so large central enterprises in sec- other nonstate sector. Indeed, the state sec- tors such as electricity, petroleum, aviation, tor’s share in the total number of industrial and telecommunications) remained largely enterprises (with annual sales over RMB 5 state owned. Even here, much progress was million) fell from 39.2 percent in 1998 to 4.5 made. Many SOEs were corporatized, radi- percent in 2010. During this same period, the cally restructured (including the shedding of SOE share in total industrial assets fell from labor), and expected to operate at a prot fi . In 68.8 percent to 42.4 percent, while the SOE some sectors, intra-SOE competition was pro- share in employment was slashed from 60.5 moted, and the scope for private participation percent to 19.4 percent (figure 1.4). The SOE was expanded. Later, the 2003 establishment share in China’s exports fell from 57 percent of the State Owned Assets Supervision and in 1997 to 15 percent in 2010. As a result, the Administration Commission (SASAC) to exer- nonstate sector has become not only the main cise authority over large centrally run firms generator of output (an estimated 70 percent laid a foundation for future improvements in of GDP) and employment and the strongest governance and investment planning. engine of growth but also the most active sec- As a result, the profitability of China’s tor for innovation. According to one source, SOEs increased. Their reported average 65 percent of China’s patents and 75 percent return on equity (ROE) jumped from only Percent c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 105 FIGURE 1.5 The rate of return for nonstate firms manufacturing sectors. In some “strategic” exceeds that of So Es or “pillar” sectors (airlines, telecoms, and the like), some inter-SOE competition was encouraged by the breaking up and corpo- ratization of incumbent providers. China’s 20 opening to the outside world, especially its accession to the World Trade Organiza- tion (WTO) in 2001, enhanced competition from abroad. Finally, the more recent phas- ing out of incentives that had favored foreign investors enhanced competition by leveling the playing field with domestically owned firms. For this reason, and also because of 1998 2000 2002 2004 2006 2008 2010 China’s vast size, the overall industrial sector Return on equity is not very concentrated (box 1.6), suggest- For industrial enterprises For SOEs ing strong potential for competition between For non-SOEs individual firms. Competition remains curtailed in one key Source: National Bureau of Statistics (China), various years. dimension, however—between state-owned and nonstate parts of certain sectors— 2.2 percent in 1996 to 15.7 percent in 2007, especially in “strategic” industries and utili- before sliding back somewhat to 10.9 percent ties. Large SOEs dominate certain activities in 2009 (figure 1.5). not because they are competitive enough to However, the average prot fi ability of SOEs keep the dominance but because the market remains well below that of nonstate (includ- competition is restricted and they are granted ing private) firms. In 2009, the average ROE oligopolistic status by the authorities (Lin of nonstate firms had declined somewhat but 2010). The weak and unfair competition still remained 9.9 percentage points above resulting from such “administrative monop- that of SOEs. In addition, a disproportion- oly” (box 1.7) has been deemed “the current ate share of SOE profits comes from a few problem facing private enterprise in China” monopolies that earn artificially high rates (Naughton 2011) and “the major source of of return because of limits on competition, monopolies in China’s economy” (Owen and while SOEs as a class have enjoyed access to Zheng 2007). The strong direct ties between cheaper capital, land, and natural resources. the government and incumbent SOEs, espe- As a result, the profitability of SOEs in cially large SOEs, limit equitable market less-state-dominated sectors is generally entry opportunities, hampering the efficient poorer, suggesting an even greater underlying use and equal allocation of resources and advantage for nonstate firms. The superior restraining entrepreneurship and innovation. performance of private and other nonstate The most problematic form of government firms is also confirmed by a wide range of intervention in competition and administra- other research, although the financial per- tive monopoly in China is official lists that formance of some SOEs has been weak in grant SOEs an exclusive or privileged role in part because they have been responsible for certain sectors. Two lists stand out. First, in delivering public services or have been con- 2006, China identified seven “strategic” sec - strained by regulated prices. tors in which the state would keep “absolute A significant expansion of competition control”—defense, electricity generation and contributed to productivity gains (World distribution, petroleum and petrochemicals, Bank 2009c). Privatization and market telecoms, coal, civil aviation, and water- reform generated vibrant competition in most way transport. While a handful of state Percent 106 china 2 0 3 0 Box 1.6 China’s industrial concentration remains low in most sectors Sutherland and Ning (2008) compare the evolution tribution of electric power and heat. These indus- of industrial concentration in China with that of tries accounted for only 14.4 percent of total sales earlier periods in Japan and the Republic of Korea. across the 37 surveyed industries. Only 5 of the 37 While such international comparisons are hampered industries had eight-firm (C8) concentration ratios by lack of strict comparability of data, they remain above 40 percent. By these definitions, only a small instructive. The authors use data from Amsden and share of Chinese industry, found in traditional pil- Singh (1994), which shows that in Japan the aver- lar industries, could be considered uncompetitive by age (unweighted) three-firm (C3) concentration ratio these rather crude but often used metrics. was 57.6 in 1937, 53.5 in 1950, and 44.1 in 1962. In The Organisation for Economic Co-operation Korea, the all-industry average C3 ratio was 62.9 in and Development (OECD 2010) also finds that stan - the 1980s. For China, the authors calculate a four- dard measures of concentration are relatively low and firm (C4) average of only 23. Thus, Chinese industry declining in China. Using the Herfindahl-Hirschman appears significantly less concentrated than Japan index, and grouping results by U.S. Department and Korea in earlier periods. of Justice merger thresholds, OECD finds that the Looking at individual sectors, Sutherland and number of industrial sectors at the four-digit level Ning find only three industries in which the C4 deemed to be highly or moderately concentrated has ratio exceeded 40 in 2006: extraction of petroleum decreased from 27 percent in 1998 to only 14 percent and natural gas; processing of petroleum, coking, in 2007. This is low compared with other countries, processing of nuclear fuel; and production and dis- including the United States. technology, construction, steel, base metals, Box 1.7 Administrative monopoly and chemicals—the state has retained “some- what strong influence” (Owen and Zheng 2007). In such sectors, private participants “Administrative monopoly” refers to market power may face a range of entry barriers or other artificially created by government policies that restrict constraints. Also, the clear signaling of the competition or compel anticompetitive conduct. It dif- expected leading role of state enterprises may fers from a natural monopoly, where market power lead private firms to conclude that they would derives from structural factors such as economies of not be allowed to grow “too big” and thus scale or scope. In China, the most important govern- ment policies contributing to administrative monopoly may act as a powerful disincentive to expan- are explicit or implicit restrictions on (private and sion if not entry. As described in box 1.8, foreign) entry into (or expansion of capacity within) such barriers to entry and exit can reduce a still rather wide range of activities, particularly in potential growth of both GDP and TFP. services. They can also include government-mandated These lists are long by high-income coun- use of specific products or services, or discriminatory try standards and include many activities treatment of nonlocal firms or products by local gov - where vigorous competition is feasible. Most ernments (“regional blockades”). These policies can be countries rightly limit entry into bona fide exacerbated by government agencies requiring approv- “natural monopoly” sectors. Until strong als for a range of activities, at times in the absence of regulatory capacity has been established, statutory authority. there may also be a case for keeping such firms state owned. However, even in such firms might compete with one another in sectors, technological advances have made these sectors, they are protected from new large subsections potentially competitive, entry (Naughton 2007). Second, in desig- including much of the telecoms sector and a nated “basic or pillar” industries—includ- good part of electricity generation and distri- ing machinery, automobiles, information bution. Furthermore, in most high-income c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 107 Box 1.8 Entry, exit, and “creative destruction” Rates of entry and exit in China have been signifi - Several new studies suggest that dynamic economies cant, but possibly different across market segments. with sustained high TFP growth tend to have rela- Strong entry and exit is critical for competition. tively rapid turnover among large industrial enter- Brandt, Van Biesbroeck, and Zhang (2009) find prises. For example, Fogel, Morck, and Yeung (2007) that China has derived a large share of its total fac- study the impact of the stability of the top 10 firms tor productivity growth from massive entry of new, in GDP and TFP growth in 44 countries. They find productive firms and exit of inefficient incumbents. faster growth in countries where big business is less Over their sample period, net entry contributed stable, that is, where “upstart firms undermin[e] more than two-thirds of total productivity growth, stagnant behemoths.” This relationship is particu- even more than its contribution in U.S. manufac- larly strong among higher-income countries. While turing. However, this average could hide variation rapid growth in low-income countries can arise from across firms of different sizes, sectors, and owner - improved factor reallocation, higher-income coun- ship. Emerging evidence suggests that such creative tries also need “creative destruction” to push out destruction is indeed strong among smaller firms. the frontier and develop a more dynamic industrial Low turnover among larger companies could sector. work to limit gains in productivity going forward. countries, vibrant competition and extensive to government-allocated resources such as private participation now exist even in sectors bank credit (see discussion of financial sector that China has deemed “strategic,” such as below). This greater predictability and cost coal mining and air transportation. Most, if advantage has allowed SOEs to undertake not all, of China’s current “basic and pillar” longer-term investment and maintain greater industries are inherently competitive, and slack in the form of inventories. In contrast, their counterparts in high-income countries less effective property rights protection and are not (or are no longer) subject to high lev- less access to government-allocated resources els of government ownership. Thus, adminis- has forced nonstate firms to take a shorter- trative barriers may be precluding significant term perspective and focus more on low-cost efficiency-enhancing competition in China. production and market-allocated resources. Policies that create an unlevel playing field or increase the uncertainty faced by busi- Industrial Interventions nesses further limit efficiency gains. As a result, state and nonstate firms coexist while Finally, since the late 1980s, the Chinese behaving differently in the face of very dif- authorities have implemented extensive inter- ferent incentives, leading to distortions in ventions, including industrial administrations resource allocation. While nonstate firms and industrial policies. Industrial admin- have driven China’s rapid economic growth, istrations include administrative approval less efficient SOEs remain in business. In a (shen pi) or reporting (bei an), administra- detailed examination of the relative perfor- tive inspection, mandatory closure of busi- mance of these two groups of firms (using ness, and other controls on firms that are China’s industrial census data), Li and Xia deemed to have inappropriate industrial (2008) seek to explain how firms with differ - activities. Industrial policies are more formal ent ownerships deploy resources and formu- than industrial administrations but they are late strategies to achieve their goals. While often connected. In broad terms, industrial nonstate firms outperform SOEs in labor interventions are designed to affect the allo- productivity, cost control, and profitability, cation of resources among economic activi- SOEs have had better and more stable access ties (across or within sectors) to achieve a 108 china 2 0 3 0 different outcome from what otherwise purposes. For example, while the central would have occurred. Such policies are most government may have aimed to consolidate a critical in sectors with both state and private sector nationally, several provinces may have ownership, but with a dominant role envis- sought to make it a “pillar” for their own aged for SOEs. They have involved a range economy. With over 30 provincial and many of actors across all levels of government more subprovincial authorities involved, the applying a variety of instruments to achieve degree to which a particular sector is ulti- multiple objectives across a large part of the mately favored or discouraged becomes hard enterprise sector. to discern. Enterprises facing such compet- Such interventions are implemented by ing pressures face a treacherous business three broad classes of actors (see annex 1B environment. for details). The first are high-level national As in any country, views on the over- bodies. The second are central government all effectiveness of industrial policies vary departments, including the National Devel- widely. As might be expected, the more opment and Reform Commission (NDRC), positive evaluations tend to come from gov- the Ministry of Industry and Information ernment institutions, while more critical Technology (MIIT), and others. The third are perspectives tend to come from academic subnational governments and their depart- specialists. There is more agreement on ments. While such governments are expected positive achievements in some more specific to help execute national policy, their exten- instances, for example regarding policies sive responsibilities also give them the means directed toward the textiles sector in the to inu fl ence industrial development, such as late 1990s. Many also argue that excess industrial planning, fiscal policy, access to capacity would have been even worse in the land, and ownership of local SOEs. absence of efforts to restrain capacity expan- The noted actors use at least five types of sion, for example in the steel industry over instruments to pursue industrial interventions. the past decade. These are policy statements; legislation; res- However, China’s industrial policy has olutions (of government departments or min- been unsuccessful in at least two dimensions. istries, which require the subordinated system First, actual developments have often dif- to follow); written and oral instructions; and fered from those programmed by the authori- “special inspection and reorganization.” ties. In some cases, targeted sectors failed As elaborated in annex 1B, China’s indus- to emerge. For example, in 1982, the State trial policies have had seven defining charac - Council set out to promote the Very Large teristics. First, they have been scale oriented, Scale Integration (VLSI) industry. While that is, they have focused on the develop- these efforts were supported with significant ment of larger enterprises. As such, they have funds from the 7th to 10th 5YP periods, the disfavored SMEs. Second, they have sought result was disappointing. In other cases, the to control the expansion of sectors deemed sectors did emerge but on a slower timetable. to have excess capacity. Third, they have For example, the auto industry was identified aimed to concentrate sectors deemed to be as a “pillar industry” as early as the 7th 5YP too fragmented. Fourth, policies to encour- period 1986–1990. Despite being nurtured, age technological advancement, such as the industry made little progress during the requirements to use specific (local) technolo - 1990s, probably because China had not yet gies, have had industrial policy dimensions. reached a level of income that would sup- Fifth, they have relied heavily on direct port rapid growth of auto ownership. The administrative intervention to introduce sector took off only in the past decade after (withdraw) resources from preferential (pro- incomes had risen and China had joined the hibited) sectors. Sixth, they have often fea- WTO. Finally, other industries flourished tured multidivision joint action. Finally, and without being picked as winners, such as the importantly, such policies have been pursued construction machinery cluster in Changsha, at each level of government, often at cross Hunan Province. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 109 Second, and most strikingly, despite con- at the “commanding heights” of indus- certed efforts to increase concentration, and try. The resulting overabundant resource despite much merger and acquisition activ- flows to (often less efficient) larger SOEs ity, industries subjected to industrial policy helped keep these firms alive while hold - have often fragmented further. Under the ing back SMEs. Furthermore, the scale 10th 5YP, the authorities tried to increase the orientation of policy can encourage Chi- market share of the top 10 iron and steel pro- nese firms to expand simply as a means of ducers from 50 percent in 2000 to 80 percent gaining policy support. in 2005 (OECD 2006). In fact, this share 2. The frequent use of direct administrative dropped to 34.6 percent in 2004 before rising intervention raises the level of uncer- somewhat to 43 percent in 2009. Similarly, in tainty faced by unfavored firms, worsen - 1994, the central government published “the ing their investment climate. Industries development policy for China’s auto indus- with long-term perspectives require a try,” which aimed to nurture two or three predictable environment for innovation, large auto companies during the remainder upgrading, and growth. Firms that fear of the 20th century. In fact, the concentra- the unexpected imposition of direct regu- tion ratio of the auto industry remained very lation, forced or “encouraged” merger, low and tended to decline over the 1990s or even closure will be more reluctant to (Hu 2008). While the central authorities can invest. strongly influence the expansion of major 3. The tensions created by competing poli- producers, other firms are also expanding. cies of agencies across and within various One key reason for the ineffectiveness levels of government further complicate of China’s industrial policies is the coun- doing business. Each actor can have try’s five-layer government. In addition, the very different objectives, even within a incentives faced by local officials exacerbate given level of government. The roles and the fragmentation of strategically important responsibilities of each player are not sectors. Large industrial firms are important clearly delimited, with overlap leading to local employers and taxpayers. Because local confusion. The result is policies that pull authorities are entitled to 25 percent of the firms in many different directions, with VAT levied on products produced in their unclear net impact. jurisdiction, they may protect existing firms or compete vigorously to attract new ones. Compared with industrial policies, Chi- Local officials become especially anxious na’s “industrial administrations” are more about cross-provincial mergers that could cut heavily criticized. In particular, the use of local jobs or transfer the tax base to another discretionary powers and the regulatory jurisdiction. In some cases, these may be the approval system can lead to rent seeking and same firms that central authorities are seek - corruption and worsen the business envi- ing to close, for example because they use ronment. Industrial interventions provide a inefficient technology or produce high levels basis for the close direct links between gov- of pollution. Informational asymmetries and ernment and business. They have also been pressure from local interests can exacerbate broad (affecting an unusually large share of such tensions. the economy); often direct and intrusive; and Finally, industrial policies affect enterprise applied by many players using many instru- performance through three other channels: ments (Jiang and Li 2010; Shi and Wang 2011). 1. By discriminating between firms of dif - ferent size and ownership, industrial Enterprise Sector Reforms to Achieve policies distort resource allocation. The China’s 2030 Vision “scale focus” of industrial policy works to favor larger firms, implying a bias To generate the productivity gains and toward SOEs that have the leading role enhanced innovation that can underpin 110 china 2 0 3 0 further rapid growth, and thus get China state ownership is deemed strong, the focus on a critical path for achieving its vision by could shift to strengthening the governance 2030, China needs to: (boards and management) of such firms, and to regulating them effectively (see below). 1. Improve technical and allocative effi- Such a review would be facilitated by a ciency by restructuring the state sector and clear state ownership policy that addresses further enhancing competition between both short- and long-term issues in the state state-owned and private firms, especially sector. Given the explicit or implicit (from by scaling back the state sector and tack- force of habit) role of ownership in China’s ling “administrative monopolies.” current industrial policy, this policy could 2. Improve allocative efficiency by fur- include an elaboration of the envisaged role ther leveling the playing field, especially for SOEs in the economy. Such a statement between small and large firms, and could serve as a benchmark against which implicitly between state and nonstate more specific policies would be measured. firms. In 1999, a CPC plenum tried to define the 3. Meet new challenges and improve the function of state ownership, listing four areas business environment by moving to more to be controlled by state firms: state safety, limited, consistent, predictable, and mar- natural monopolies, public goods sectors, ket friendly industrial interventions. and important enterprises in pillar and high- tech sectors. However, this declaration was All three spheres of policy relate primar- not a clear state ownership policy, nor has ily to larger enterprises. While the agenda for it been well implemented. In 2006, SASAC enterprise sector and business environment declared that the state should have “abso- reforms in China is much broader, the com- lute control” in seven sectors and “somewhat manding heights of the economy offer the strong influence” in nine others. Going for - greatest potential for further efficiency gains, ward, the redefinition of China’s state own - reduced imbalances, and limits on direct ership policy should emphasize that state links between government and business. ownership should primarily focus on provi- sion of public goods. Restructuring the state sector and enhanc- China could also make efforts to further ing competition between SOEs and non- downsize its state sector by a new round of SOEs. To begin tackling “administrative SOE restructuring. In the late-1990s, some monopolies,” the authorities could review the Chinese economists called for a “strate- lists that give SOEs a privileged role in strate- gic restructuring of the state sector” (Wu, gic and basic and pillar industries. In China, Zhang, and Liu 1998). The 15th Congress these lists are very broad. They include sec- of the CPC decided to carry out this strat- tors that are rather open in most high-income egy. However, its implementation seems to countries, and where the rationale for state have been frozen in recent years after nota- ownership is not obvious, especially because ble progress during 1998–2003. Accord- the state could achieve its objectives through ing to recent research (Zhang 2010), state regulation and law enforcement. If this review ownership is present in almost all competi- does identify sectors or subsectors for removal tive sectors. For example, 20,296 SOEs— from such lists, the authorities could next 17.8 percent of all SOEs—are involved in identify and cancel the explicit or implicit bar- wholesale trade, retailing, and restaurants. riers that unreasonably limit competition in The downsizing of the state sector in the such sectors. A clear signal could be sent that late 1990s and early 2000s was in reaction the evolution of such sectors will now indeed to serious financial distress. While ulti- be on a level playing field. Such steps can be mately successful, it came at a high cost of taken unilaterally without changes in the about RMB 2 trillion. To limit such costs Anti-Monopoly Law. Where the rationale for going forward, further front-loaded SOE c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 111 restructuring would ideally be more proac- private delivery of public goods and services tive, rather than done in response to crisis, (with public financing) introduces the added and be driven by the objectives of chang- dimension of competition and helps lower ing to the growth model needed to move to production and distribution costs. high-income status. Without further down- The response to the second question is less sizing of the state sector, it will be hard to straightforward. First, the government could create a fair competition environment for securitize its implicit equity in state enterprises private firms and to limit the direct ties (in listed state enterprises, the value of the between government and business. equity is already known) as soon as possible. Government ownership of enterprises is Securitization would pave the way for state widespread and varied, covering most sec- enterprise reform by separating ownership tors and ranging from outright ownership to from management and introducing modern controlling interest to minority shareholder. corporate governance practices—appoint- The challenge for further SOE restructuring ment of senior management, public disclosure is thus twofold: how can public resources be of accounts in accordance with international best used; and how can China best transi- practice, external auditing, and so on. Sec- tion from its current approach to managing ond, the government could consider estab- its portfolio of state enterprises to one that lishing one or more state asset management is best suited for its long-term development companies (SAMCs) that would represent the objectives. government as shareholder and would pro- The response to the first challenge is fessionally manage and trade these assets in straightforward. Public resources should financial markets where feasible. Each SAMC be used solely for the provision of public could specialize in certain sectors. They goods and services—the production or con- could then, on behalf of government, gradu- sumption of which result in unremunerated ally diversify the portfolio and scale back positive externalities. These can range from state ownership over time. The dividends of defense at one end of a continuum to infra- state enterprises would need to be paid to the structure, social protection, and basic R&D SAMCs who, in turn, would transfer them to at the other—and the scope could evolve as the budget. Finally, a portion of state assets conditions change. The recent emphasis on could be transferred to the national pension public housing for the poor is a good exam- fund with the flow of returns being used to ple of how government resources can be used help meet future pension obligations. to address a pressing social need. Indeed, the While the operational details of the pro- scope of public goods and services is quite posed SAMCs can be elaborated later, it is broad and can even include reliable energy important that key principles are established supplies and the widespread availability of early. It is critical, for example, that SASAC communications and postal facilities. The confine itself to policy making and oversight, share of public resources applied in a par- leaving asset management to the SAMCs. ticular area will depend on the nature of The SAMCs should have clear mandates, be the public good or service being supplied. In independently and professionally managed, areas considered to be of high national pri- and be subject to publicly announced perfor- ority, such as defense, government resources mance benchmarks (depending on the nature would be expected to provide the full or of the enterprises in their portfolio). In addi- dominant share of finance. But in most areas, tion, they will need to adhere to international a smaller share is usually sufficient to achieve standards for transparency, including on the government’s objectives. Most impor- operations and results, value creation, prot fi - tant, in many cases, private sector firms ability, and dividend payments. are fully capable of delivering public goods In the medium term, the expanded scope and services, even though the government for private participation could be comple- may provide the bulk of the finance. The mented by the restructuring of remaining 112 china 2 0 3 0 SOEs. Building on China’s own past expe- laws grant exemptions or exceptions to par- rience with corporatizing and restructuring ticular industries and certain types of eco- SOEs, more such large enterprises, espe- nomic activities and transactions (UNCTAD cially those parent companies supervised by 2002). Exemptions may be sectoral in nature, the central and provincial SASACs, could such as a “natural monopoly,” or functional, be restructured to mixed ownership enter- such as development of product standards or prises and listed corporations. Furthermore, other practices where a single or few provid- governments could reduce their ownership ers makes great sense. Some such exemptions shares in those firms and build up modern might be necessary for furthering the objec- governance featuring professional manage- tives of competition policy. Other exemptions ment. One additional benefit of narrowing reflect pressures from special interest groups. the scope of the SOE sector would be to In many cases, there is a clear need to revisit strengthen SASAC’s capacity to supervise its such exemptions. The UNCTAD report offers remaining SOEs. some general recommendations concern- Also in the medium term, China could ing procedures and principles for granting further spur competition by strengthen- exemptions. After applying such principles, ing the Anti-Monopoly Law in two ways. the number, nature, and scope of exemptions First, it could further rein in administra- will tend to be more limited and procedures tive monopoly by making relevant clauses more accountable and transparent. of the law clearer and more restrictive. Chi- na’s new Anti-Monopoly Law, enacted in Further leveling the playing field. Greater 2008, devotes one chapter to administrative competition needs to go hand in hand with monopolies and their impact on competition, fairer competition. This would enhance alloc- broadly declaring them illegal. However, in ative efc fi iency by helping direct factors of pro - its current version, the law lacks teeth. The duction toward their most productive uses. To clauses are very simple and focused on the this end, firms of different size or ownership cross-regional trade in goods. Moreover, the should compete on a more level playing field, current law is not actionable, leaving enforce- not only in a strict legal sense, but also in the ment as a voluntary matter for “higher terms on which they gain access to inputs. authorities.” The relevant provisions are The most promising near-term reforms explicitly subordinate to other laws and regu- to address this issue are outside the scope of lations, almost guaranteeing that they will be competition policy and would directly tackle overridden. Within government, application key distortions. These include the preferen- and enforcement is spread out across several tial access to credit by larger firms or SOEs, agencies. Such a cautious approach could including access resulting from moral h azard well make sense at the beginning. Given the (see financial sector discussion below); the importance of administrative monopolies, still low level of SOE dividend payments a law that made no mention of them would (which can leave savings within firms to be be incomplete. On the other hand, an overly deployed less effectively than in other pos- ambitious approach (beyond the initial capac- sible uses); and the implicit advantages that ity to enforce) could also erode authority of SOEs gain by their closeness to decision mak- the law itself. For example, the Anti-Monop- ers (including through the ministerial status oly Enforcement Agency would have to bring of CEOs of large firms. A review of indus - cases against other parts of government at the trial policies (see below) to remove explicit or same or higher rank. Clearly, enforcement of implicit biases in favor of firms of particular these provisions of the law will require both scale or ownership would also address such legal amendments and strong political will, concerns. including high-level support to the enforce- In the medium term, fairer competition ment authorities. could be promoted by developing and enact- Second, the scope for exemptions from the ing a set of laws that would limit potentially law could also be reviewed. All competition distortive discretionary actions, including in c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 113 the realm of industrial policy. By defining past 30 years, it may have at times played a clear “rules of the game,” such laws would positive role in China’s objective of “catch- be in the same spirit as the limits that the ing up.” However, China’s current system WTO places on its members’ trade poli- of industrial interventions could become an cies, or that the U.S. Constitution places on obstacle to achieving the innovation-driven restricting interstate commerce. Such rules growth to which the country now aspires. In could contain some of the most egregious distilling lessons of East Asian industrial pol- attempts by central and subnational officials icy, Weiss (2005) notes that for higher-income to pull in different directions using crude emerging economies, the agenda will be to administrative means. One such law is the upgrade export structure and move up the Anti-Monopoly Law, which has already value chain. For these economies, old-style been discussed. If a strengthened law still left industrial policy of “second guessing” the important gaps, it could be complemented market and creating winners will have less rel- by additional legislation (possibly in the evance. Instead, these economies will require form of a special law) to restrict currently a business climate that is more favorable to widespread industrial interventions by cen- SMEs and new entrants, that encourages tral or subnational governments. This law fair competition, that is more tolerant of low should be actionable, with any governmen- sectoral concentration and excess capacity, tal departments liable to be charged if they and that relies more on market mechanisms. impose interventions restricted by the law. The type of innovation that China seeks to In the longer term, to safeguard fair com- unleash can initially result in rash new entry, petition in a single market, China could ferocious competition, fragmentation, and consider enshrining limits on the financial excessive investment, developments that need support that its governments can directly or not be unhealthy in industries that have yet indirectly provide to firms. One recent exam - to mature. ple is large capital injections into major state- Reform of industrial policy should start owned airlines (Pan 2010). Such support, by from a clear elaboration of its role and pur- allowing some firms to absorb losses that a pose. Which market failures, externalities, purely commercial entity would not or could or other circumstances need to exist for such not absorb, results in unfair competition. To policies to be applied? As Leipziger and oth- counter such tendencies, China should pro- ers (1997) note, governments that follow a vide its governments with clear rules of the “hunch” to support a particularly prestigious game in dealing with inevitable pressures for industry without clear evidence of a market aid of one form or another (Leipziger and failure, or that identify favored sectors based others 1997). This could build on experience on noneconomic criteria, will impose a high of the European Union (EU) in implement- fiscal cost and generally fail. Such principles ing rules on “state aid.” While the EU and could be published to ensure transparency China have many important differences, they concerning policy objectives and the moni- face similar problem of regulating anticom- toring and evaluation of results. petitive behavior either by member states (in Based on this clear elaboration, policies the EU case) or by subnational authorities (in themselves would be more focused, imple- China’s case). The EU experience emphasizes mented by fewer actors, simpler, and more the necessity of a credible institutional frame- market friendly. As noted, China’s current work to monitor industrial subsidy programs industrial interventions can be extensive, and enforce mutually agreed rules for indus- inconsistent, unpredictable, and administra- trial policy. tive. Greater focus means limiting their appli- cation to a few sectors where the case for Focusing and modernizing “industrial poli- such policies is strongest. That would avoid cies.” China’s industrial policy needs to adapt spreading scarce technical and entrepreneur- to changing circumstances. While such policy ial talent too thinly and crowding other estab- did not always work as expected during the lished sectors with comparative advantage 114 china 2 0 3 0 out of input and factor markets (Westphal national priorities. To the extent that local 1990). The involvement of fewer actors (see industrial policy is motivated by the desire below) would add coherence to policy. A for more revenues, different sharing rules for more limited set of permissible interven- key taxes (especially the VAT) might reduce tions, including the provision of any support incentives for fragmentation. Similarly, per- through fiscal rather than banking channels, formance evaluation that goes well beyond would promote greater transparency and indicators of local GDP growth could limit reduce collateral distortions in other markets excessive desire to attract or preserve indus- (Leipziger and others 1997). For example, tries in need of consolidation. All of this is a pursuit of more general objectives, such as matter of degree, because competition among consolidation of a sector, without prejudice subnational units has also had positive fea- toward specific (incumbent) firms, would tures, and those features should be preserved. avoid discrimination against potentially more Any deeper realignment of incentives would innovative new firms. Support should be tem - require more fundamental changes to the porary and subject to strict “sunset clauses.” relationship between levels of government in The selection mechanism should lean toward China, which we do not consider here. innovation ability instead of scale and owner- Finally, as a general issue cutting across ship. Finally, policies should try to work with the themes discussed above, the assignment the market, harnessing its power to achieve of functions related to ownership, policy, desired aims, rather than against it. For and regulation across government agencies example, using market forces to spur merg- needs to be rationalized. As a result of indi- ers and acquisitions (by making more shares vidually sound but piecemeal reforms, China tradable for example) would promote concen- now has a range of agencies with multiple tration without prejudicing its outcome. and overlapping functions. For example, in China’s unique size, complexity, and high addition to its core function of supervising degree of decentralization should also affect state ownership in SOEs, SASAC also retains the form of its industrial policies. Specific certain r egulatory and policy-making roles. approaches that may have worked well in Similarly, responsibility for enforcing the smaller and more centralized economies such Anti-Monopoly Law is split between three as Japan, Korea, and Singapore could be agencies with other broader responsibili- problematic in China. With multiple layers ties—the State Administration for Industry of government possessing significant de facto and Commerce (SAIC), the Ministry of Com- autonomy, the central authorities could for- merce (MOFCOM), and the NDRC. For mulate policy but find it very hard to monitor example, MOFCOM is charged with encour- or enforce. Within a given level of govern- aging foreign direct investment. Some SOEs, ment, numerous agencies with overlapping such as the tobacco enterprise, even retain mandates can pull in different directions. responsibilities for sector policy while also Local governments seeking to generate new seeking to earn a good return. This arrange- jobs or tax revenues will have clear incen- ment compounds already severe fragmenta- tives to protect existing enterprises or attract tion across levels of government and tensions new ones by providing resources such as land between various stakeholders. Such fragmen- at a steep discount, by helping navigate the tation can lead to a blunted focus, duplication required permits and approvals, or by hinder- of efforts, conflicts of interest, and weakened ing or blocking cross-border mergers. Such responsibility. forces can exacerbate industrial fragmenta- Going forward, China could review cur- tion, frustrating central government efforts rent functions and responsibilities, reallocat- to consolidate. ing them so that one body would be the lead Changes in tax-sharing rules and in (if not sole) agency in a given area. For exam- performance evaluation of local officials ple, SASAC could focus entirely on the nar- can help better align their incentives with row mandate of maintaining and increasing c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 115 the value of public assets. As in most high- banks were introduced by selling a portion income countries, a single government body of shares to strategic investors and listing would implement and enforce competition them on domestic and foreign exchanges. policy. A third agency (such as the NDRC) Entry restrictions on financial institutions could take sole charge of industrial policy. and controls on capital flows were somewhat Enterprises would be charged with doing eased. Important regulatory reforms were business. Focused bodies will individually undertaken by institutional restructuring be more effective and work more coherently and introduction of global standards. Vari- together. There has been some progress in ous measures were introduced to boost the establishing separate sectoral regulatory bod- development of securities markets. ies—this needs to continue. Despite the many reforms introduced so The performance of China’s enterprise far, the Chinese financial system remains sector can also be improved by other reforms repressed, unbalanced, costly to maintain, beyond the realm of industrial policy. These and potentially unstable. include issues on the general business climate, remaining barriers to a deeply integrated • Repressed. Pervasive controls remain in single national market, strengthening intel- key areas. The levels of state ownership in lectual property rights, public procurement the banking sector (g fi ure 1.6) and govern - reform, contract enforcement, bankruptcy ment intervention in the financial system regimes, and trade policy, improving access are much higher than in other countries at to finance, and strengthening corporate a similar stage of economic development governance. that later achieved high-income status. Despite changes in the ownership structure of commercial banks from the previous Financial System Reforms system of exclusive state ownership to the current system of joint-stock ownership, China’s Financial System Developments the government continues to dominate to 2010 in the financial sector. Continued protec - The Chinese financial system has served the tion and intervention in the business deci- purpose of savings mobilization and capi- sions of financial institutions make them tal allocation to strategic sectors during the catch-up stage of economic development. It FIGURE 1.6 o wnership structure of the banking was successfully transformed from a social- sector, 2005 ist fund allocation system to a system that has proved effective for financing a rapid expansion of investment and thereby eco- nomic growth during the past three decades. The banking system has mobilized sufficient national savings to meet high investment 60 demand by firms and local governments. Its extensive branch network, perceived stability by depositors in state-owned banks, reason- ably stable inflation, and high household sav - ings rate, among other things, have contrib- China India Brazil Russian Korea, uted to this successful role. Federation Rep. The past decade has also witnessed impor- Foreign Private Public tant progress in reforming and restructuring the financial system. There has been prog- Source: World Bank Financial Regulation and Supervision database. ress in interest rate liberalization. Reforms in Note: The figure shows the share of banking sector assets held by the governance of state-owned commercial majority-foreign, private domestic, and state-owned banks. % owned 116 china 2 0 3 0 convenient policy instruments, the use of far, China has not taken full advantage of which prolongs the bureaucratic culture these complementarities. If the histories of and distorted incentives that have pre- high-income countries are a reliable guide, vented banks from full commercialization China’s future development likely hinges and from allocation of financial resources on achieving a more balanced financial to the most productive uses. system. Additional imbalance is found in • Unbalanced. Despite recent efforts to pro- the capital market in which the share of mote direct financing, bank credit still the fixed-income market is overwhelmed accounts for close to 90 percent of funds by the equities market, and the share of raised by the corporate sector. While it is corporate bonds market remains small. not uncommon for financial systems to be • Costly to maintain. The financial system weighted toward banks at China’s stage of is exposed to accumulated losses yet to be development, international comparisons fully absorbed and new losses in the mak- show that China’s is especially so (figure ing. Banks have been used as instruments 1.7 and annex 1C). Recent research indi- of the government’s macroeconomic and cates that the optimal financial structure sectoral policy goals and have not always becomes more market oriented as econo- been in a position to lend prudently. While mies develop (Demirgüç-Kunt, Feyen, this approach may have helped achieve and Levine 2011). This is consistent with policy goals, it has also exposed banks to theoretical arguments that economic a greater risk of deteriorating loan portfo- development increases the demand for lios, increasing the ultimate costs of such the services provided by nonbank finan - public policies. Rounds of capital injec- cial institutions (NBFIs) and the securities tions into state-owned commercial banks markets relative to services provided by and disposal of nonperforming loans at banks. The histories of developed coun- the end of the 1990s and before public tries such as Britain, Germany, Japan, listing of their shares, not to mention the and the United States also indicate major reported losses on lending to local govern- complementarities in the functioning and ments incurred since 2008, are indica- development of banking systems and secu- tive of the magnitude of real and potential rities markets (Allen and others 2010). So costs to the government budget. • Potentially unstable. The financial system is fragile and vulnerable to potential insta- bility for several reasons. Systemic risks FIGURE 1.7 Financial system structure in comparison, 2009 are embedded in the homogeneous behav- ior and operations of financial institu- tions, in part reflecting weak commercial orientation; in the widespread financial services integration and conglomeration 60 that has been going on for years without a strong regulatory framework to moni- tor, measure, and mitigate risks across the financial services industries; in the rapid growth of shadow banking activities that, while providing useful channels to those China Russian Japan Korea, Brazil India United underserved segments of the economy, Federation Rep. States are largely out of the official oversight; Stock market cap Government bonds and in the large overhang of local govern- Nongovernment bonds Bank credit ment debts mentioned earlier. A major component of the financial safety net—the Sources: Bank for International Settlements, China Securities Regulatory Commission, IMF International Financial Statistics, World Development Indicators. deposit insurance scheme—has yet to be Percent c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 117 created more than 10 years since its ini- future financial system should be free of tiation. The mechanism for resolution of repression and strike a balance between the troubled banks has not been institutional- banking and nonbanking financial institu- ized and crisis management mechanisms tions and markets, especially the capital are not well established. Lack of informa- market, with more diversified institutions tion sharing and coordination among the and products reflecting the changing nature fiscal, monetary, and financial regulatory of China’s economy. Financial institutions authorities, and limited progress in build- should be commercialized and rationalized, ing up a macroprudential framework through installation of effective corporate against systemic risks, are also causes for governance, creation of a level playing field, concern. establishment of effective oversight, and lia- bility for bankruptcy regardless of ownership Overall, financial sector reform and devel - structures. The financial system should have opment have been out of step with the real better outreach to households, consumers, economy. The current financial system, char - and micro, small, and medium enterprises acterized by bank dominance and strong (MSMEs), and be able to provide long-term state intervention, served to mobilize savings and risk capital to support the upgrading and and allocate capital to strategic sectors during expansion of incumbent firms and the emer - the economic take-off, but such benefits are gence and growth of new firms in high-tech increasingly outweighed by the costs of the and emerging industries. accompanying distortions and the resulting A well-functioning financial system is buildup of imbalances and risks. China could essential in China’s drive to become a har- conceivably sustain high economic growth monious and high-income society. First, as for a while longer even without fundamental growth in the supply of labor and capital reforms in the financial sector. However, in slows, China will have to rely more on pro- such a case, distortions in resource allocation ductivity growth, which has to be supported would be intensified, income and wealth dis - by the financial system through improved tribution worsened, and internal and exter- allocation of capital. Second, the increasing nal imbalance sustained. Eventually, these importance of TFP in supporting economic distortions and imbalances would undermine growth requires innovation that cannot be social stability, slow productivity growth, realized without support from the financial and erode competitiveness. The potential system, especially a well-developed capital debilitating effect of a future forced finan - market. Third, a well-functioning financial cial liberalization, and lack of an integrated market could provide reliable monitoring and approach and concerted actions on the part corporate governance, and facilitate timely of the government, can only serve to exacer- industrial restructuring by permitting the bate the negative consequences. Now is the entry and exit of firms through various paths time for China to rethink its vision and strat- including mergers and acquisitions. Fourth, egy in the financial system, to avoid a situa - the need to rebalance the Chinese economy tion where delays in financial system reform will require an inclusive financial system that and development disrupt or impose a drag on provides widespread access to diverse finan - the real economy. cial services and products by households and by micro and small enterprises. Fifth, finance also contributes to preparing for old-age China’s 2030 Vision for the security and reducing poverty and inequality Financial Sector by improving opportunities for households to China needs to build a more liberalized, bal- borrow and invest in assets whose value can anced, efficient, safe, and sound financial grow in parallel with the economic advance- system that meets the demands of corporate, ment of China. Finally, finance that is not household, and government sectors. China’s managed well can be disruptive to economic 118 china 2 0 3 0 development, as shown in the recent financial institutions, either through direct holding of crisis and China’s own experience. shares or through indirect inu fl ences, mainly because it is heavily dependent on the use of commercial bank credit for policy goals. Key Reforms to Strengthen China’s Full commercialization of financial institu - Financial System tions will not be possible unless this practice Building a more efficient and robust financial is replaced by other mechanisms, including system that can well serve China’s transition greater use of direct fiscal expenditures, gov - toward a modern, harmonious, creative, and ernment credit programs that work through high-income society will require a systematic the banking system, rationalization of the approach to reform. For the system to embark policy banks, and reforms to intergovern- on a virtuous cycle, it will be critical for the mental fiscal relations. The goal should be to government to gradually reduce its inu fl ence first free the commercial banks from policy- in the internal affairs of the financial insti - oriented functions to enable them to compete tutions to focus on roles that belong to the with their peers from home and abroad, by government, including regulation, supervi- subjecting them to market discipline and sion, and infrastructure building, as well as effective regulation and supervision. Policy creating and enforcing the right incentives loans and government-directed loans could and mechanisms. be gradually phased out or transferred to those few policy-based banks with clear Full commercialization and rationalization mission and mandates that operate under of the financial system. Macroeconomic strictly enforced performance monitoring and financial policies and instruments need and evaluation. to be better aligned to create incentives for A commercially oriented governance sys- a lasting transformation to a more commer- tem should be introduced. While privatiza- cially oriented and effective financial system. tion would be the best way to make state Mechanisms, structures, and institutions must financial institutions (SFIs) more commer - be created that provide financial intermedia - cially oriented, privatization of the big SFIs tion without distorting incentives, exacerbat- Since the government would not be easy. ing moral hazard, and creating contingent is likely to remain majority owner of the liabilities for the government. To facilitate this commercial banks, state-ownership func- process, the government should continue to tions need to be strengthened. To be effec- reorient its roles and responsibilities, moving tive, state-ownership agencies need to act in ways similar to private owners. Otherwise, from direct controls to indirect measures. As given the multiple objectives of the govern- an example, the central bank does not have the ment, SFIs will not become truly commer- necessary independence to carry out its func- cialized. China may introduce a governance tions in monetary policy decisions. Monetary structure for banks after taking thorough policy has been conducted through frequent stock of the existing state-ownership func- changes in reserve requirement ratios, window tions, agencies, and practices, and drawing guidance, and even credit ceilings. To enable banks to better manage their assets and liabili- lessons from international best practice and ties, the central bank could conduct monetary failures (box 1.9). policy in more market-friendly ways, that is, through open market operations. Further liberalizing interest rates. China has It is important to move away from direct reached the stage where it needs to phase out or indirect control of financial institutions remaining interest rate controls. Much prog- and to develop alternatives to bank-based ress has been made in liberalizing interest funding of government policy goals. The gov- rates, but the remaining controls have been ernment at all levels has been closely involved blamed for many distortions in the finan - Such controls have played a key in the commercial operations of financial cial sector. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 119 Box 1.9 Improving the effectiveness of the state-ownership functions in the financial sector China has yet to establish consolidated and effec- government needs to spell out the long-term and tive state-ownership functions in the financial sec - overarching goals of the financial sector, explain tor. While the government has stated its intention why it needs to own financial institutions, decide to remain a dominant owner of key state financial which institutions should continue to be held and institutions (SFIs) in the long run, there has never which should be let go, and determine what level of been a clear elaboration of why direct ownership is ownership should be maintained over what period necessary for achieving its objectives. Many orga- of time and how it should be done. The rights and nizations are involved, each with responsibility for responsibilities of state-ownership agencies need to only a small aspect of ownership. None has either be clarified in the law. An ownership policy should the perspective or the authority to take a broad view be developed and published to inform the general of the financial sector. Fragmentation leads to both public as to why the government intends to own ambiguities over decision-making authority as well specific institutions and how its rights will be exer - as mismatches between rights and responsibilities. cised and ownership responsibilities distributed and Moreover, there is insufficient public information carried out. Transparency and accountability can on how the state ownership in the financial sector be enhanced by implementing a performance-moni- is organized, let alone about the objectives, man- toring system and developing aggregate reporting on dates, division of rights and responsibilities, and the performance of portfolio SFIs. In the medium to performance indicators. In this setting, a meaning- long run, a rational organizational format of func- ful monitoring and evaluation framework is not tions should be considered. However, mere orga- possible. nizational changes can fail to achieve the intended Several reforms are needed to further improve results if they are not accompanied by fundamental the effectiveness of state-ownership functions. The changes in incentives and institutions. role in the overall strategy of catching up products could raise the risk of financial cri - through strategic capital allocation to prior- sis. There will also be a need to avoid a signif- ity sectors and in protection of the banking icant asymmetry in the pace of liberalization system. However, as the economy matures, between banks and NBFIs, and between the the remaining controls become a drag on direct market and indirect market. The moral growth as artificially cheap capital contrib - hazard of financial institutions needs to be utes to overinvestment and delays restructur- properly checked to prevent destabilizing ing. The development of capital markets also interest rate competition. Effective regulation has been hindered by distorted risk pricing. to prevent excessive competition for deposits The guaranteed interest spread has prevented by bidding up interest rates and by making the formation of a true risk culture, which is loans to risky borrowers at unduly high rates key to commercial banking, capital market should be secured before liberalization of the development, and access to finance. In addi - relevant bank interest rates. tion, market-determined interest rates will be crucial for an effective movement of mon- Deepening the capital market. Deepening etary policy from direct quantitative control the capital market is conducive to a rebal- to indirect control. ancing of the financial structure and to the While the floor for lending rates is easier to catch-up strategy of innovation in science and remove because it is no longer binding, liber- technology in which innovative, vibrant pri- alization of deposit rates is a complex matter, vate firms could emerge and thrive. A coun - requiring several key prerequisites that can- try’s financial structure inu fl ences the types not be ignored. Too rapid disintermediation of industries that get financed, with equity or too rapid inflow to short-term financial finance supporting more innovative industries 120 china 2 0 3 0 and debt finance through bond issuance and willing to take risk may purchase corporate bank lending better suited to existing indus- bonds, mutual funds, and stocks. That would tries. A key advantage of capital markets rela- facilitate the flow of funds to risky entrepre - tive to banks stems from the evaluation of neurial ventures with potentially high return business opportunities by multiple potential and long-term corporate investment with a investors, whose diligence can help assess the long gestation period. The growth of asset viability of new technologies. Venture capi- management businesses could also assist tal and private equity industries will have to in providing greater financial security for play a bigger role in financing technologically the elderly (through improved vehicles for advanced industries. Institutional investors accumulating retirement savings) and, more will also play an increasingly important role broadly, for securing social cohesion and sta- in the development of China’s capital market. bility. Asset management requires less strong Deepening capital markets will also help to regulation than banks, but it does require increase the access to bank loans by house- transparency, strong investor protections, holds and MSMEs as large and established market-determined interest rates, and mark- firms rely increasingly on direct financing. to-market of assets. The government has to A market-based financial system is more provide a solid legal basis to nurture this dependent on the rule of law and market business. According to other countries’ expe- infrastructure than a bank-based system. An riences, once the market infrastructure and equitable, transparent, and efficient capital environment is provided, this business can market is not achievable without a funda- grow quickly, taking a large part of house- mental reorientation of the role of govern- hold and corporate savings. ment. The authorities should gradually reduce administrative controls where market Upgrading financial infrastructure and the mechanisms could do better. As an example, legal framework. China’s financial infra - China should move to a disclosure-based sys- structure needs to be further upgraded to tem from the current merit-based approval facilitate the financial market in general system for initial public offerings. The gov- and the capital market in particular. Finan- ernment should focus on improving the legal cial infrastructure includes many elements, framework, enforcement of laws and regu- such as credit information systems, rating lations, upgrading financial infrastructure, services, accounting and auditing, payment and imposing stringent rules on informa- and securities settlement systems, exchanges, tion disclosure. Artificial segregation of the and over-the-counter markets. While many market should be avoided. The current seg- key elements are formally already in place, mentation of regulation in the fixed-income more needs to be done to ensure their effec- market among the People’s Bank of China tive functioning. As an example, great (PBC), China Securities Regulatory Com- strides have been made in the past few years mission (CSRC), and NDRC raises concerns in C hina’s security interest filing system, about regulatory inconsistency. Their respec- as demonstrated in the registry system for tive roles should be clarified to ensure regu - accounts receivable and lease interest regis- latory consistency among different market try. What remains to be done is in the reg- segments. istration of inventory and equipment, which Growth of the asset management busi- should be centralized and Internet-based. In ness is essential to facilitate the deepening addition to the enhanced payments and secu- of the securities market. China’s financial rities settlement system, efforts may include system needs to provide a reasonable variety continuing to improve the coverage and qual- of financial products with different risk and ity of consumer credit information reporting return profiles to meet different risk prefer - as well as improving the independence and ences of investors. Risk-averse individuals can professional ethics and standards of credit choose bank deposits, while investors more rating agencies. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 121 Adequate and accurate disclosure and securities, and insurance in the financial sec - transparency supported by credible account- tor, the degree of financial conglomeration is ing and auditing practices can go a long stunning. The existing regulatory and super- way in supporting financial development by visory structure does not provide the neces- minimizing informational frictions. China’s sary monitoring and surveillance to deal legislative and regulatory framework on with the spillover of risks among financial accounting and auditing has converged to institutions and industries—the coordination international standards. However, reviews mechanism is perfunctory, and information and anecdotal evidence point to noncom- sharing is sporadic. The authorities may be pliance in the financial statements of some forced to decide whether to unify all finan - listed companies and variations in the level cial regulators under one roof or to main- of compliance with applicable auditing stan- tain the current regulatory architecture but dards. More seriously, fraudulent activities strengthen their ability to deal with cross- can cause reputational damages and loss of industry financial risks, probably through investor confidence that is hard to restore. improved functional supervision. More efforts are needed to further strengthen A well-defined and functioning macro- the capacity of the regulators, as well as to prudential framework is critically important improve the development of accounting and for China to prevent or mitigate disruptive auditing professions. Strong and strict penal- idiosyncratic risks, including those that may ties should be imposed on improper account- well emerge from the rapid growth of shadow ing and auditing practices. banking activities. Currently, there is some interagency coordination on broad financial Strengthening the regulation and supervision sector issues, but a comprehensive macropru- framework. The independence and effective- dential framework needs to be developed, ness of regulatory and supervisory bodies with a clear institutional setup (including can be enhanced. Achieving this is a chal- mandate, powers, distribution of responsi- lenging task, especially because the govern- bilities, information-sharing arrangements, ment role as both an owner and regulator of and the like). The PBC is deeply involved in major financial institutions creates potential microprudential regulation and supervision, conflicts of interest. Almost without excep - as evidenced by the differentiated approach tion, the experiences of other countries in a to required reserve ratios and capital require- similar situation bear out the failure of regu- ments and tight control of the interbank latory oversight. The risk of failure becomes market participation and operations. But the greater as financial liberalization progresses financial regulatory authorities are reluctant and competition in the financial market deep - to retreat from areas pertaining to macro- ens. China’s integration in the international prudence while not focusing fully on financial system and the internationalization microprudential regulatory and supervisory of the renminbi will put pressure on China work. While the concept of macroprudential to improve its regulation and supervision. regulation is yet to be fully defined in China, The government needs to seek institutional its importance for securing financial stability reforms to secure the political independence is being emphasized globally. of regulatory bodies to enable them to con- China could establish a high-level finan - duct arm’s-length regulation and supervision, cial committee on the basis of the existing regardless whether it would remain the owner framework, with the main objective of reduc- of financial institutions. ing systemic risk and maintaining finan- Institutional arrangements are needed to cial stability. Such a committee, if endowed better align regulatory resources and struc- with strategic significance and charged with ture to deal with increasing integration of forming an overall assessment of the finan - the financial services industry. Despite laws cial system, would not only free the State that insist upon segregation among banking, Council from its current heavy burdens, but 122 china 2 0 3 0 also enable sector supervisory authorities China should create an insolvency regime to concentrate on improving the effective- for the financial sector that would allow for ness of financial regulation and supervision. an orderly exit of weak or failing financial It would also remove obstacles between the institutions. In China, the sense of being central bank and various supervisory bod- “too big to fail” or “too connected to fail” ies in coordination and information and is deeply rooted in the state ownership and analyze and supervise all institutions, prod- control of financial institutions. Even small ucts, instruments, markets, and transactions financial institutions that fail to pay off their that might bring about systemic risks. The debt rarely go bankrupt. This situation cre- role of this financial committee could also ates the potential for rampant moral hazard. include development and establishment of Signaling in an early stage of liberalization instruments, standards, and indexes for sys- that poorly managed banks and firms could temic risk monitoring and identification, and go under would be necessary even if it entails development of macroprudential instruments substantial short-run cost. Such a regime (possibly using microprudential means as would include the designation of a resolu- transmission channel). tion authority; the legal power to intervene promptly in a nonviable financial institution; Building a financial safety net and devel - resources to close, recapitalize, or sell such an oping crisis management and insolvency institution; the capacity to manage the inter- schemes. Financial liberalization will lead vened institution, including its assets; and to a more efficient financial system but also an effective safety net. A well-functioning will increase the risk of financial instability. insolvency regime would help contain moral Most countries have faced big or small crises hazard and also protect fiscal soundness. in the process of opening their financial sys - The authorities should establish an effec- tems, often as a result of macroeconomic dis- tive exit mechanism in the legal framework tortion and volatile changes in relative prices and streamline the court system to deal with and asset values. While China’s huge foreign troubled banks and firms in a timely fashion. reserves give it a strong buffer against a pos- It should allow for an orderly exit of weak sible currency crisis, it cannot neglect the pos- or failing financial institutions and a clear sibility of a domestic financial crisis. definition of the role of the government in An early warning system would be help- providing fiscal support. The roles of the PBC ful for effective oversight, early intervention, and regulatory agencies need to be reviewed. and prevention of financial crisis. To identify For example, it is important to limit central threats, the authorities need to continue to bank emergency liquidity support to solvent deepen their financial stability analysis and banks facing short-term liquidity problems, develop a full range of early warning indica- and to establish an out-of-court settlement tors. This warning system can be composed system while streamlining the court system of two parts. The first would be a set of mac - to resolve quickly failed financial institutions. roeconomic and sectoral models, possibly A formal deposit insurance scheme is encompassing the housing market, foreign needed to deal with potential bank runs exchange market, banking sector, stock mar- on privately owned depository institutions ket, and labor market, among other things. It and to protect the savings of small deposi- could specify the range of daily, weekly, and tors (box 1.10). The preference to establish monthly changes in indicators that would dic- a deposit insurance fund instead of a multi- tate the severity of supervisory reaction. The function deposit insurance system requires second part would be to define the institu - careful consideration. If such an institution tions responsible for monitoring and report- becomes a fund only to pay for bank failures, ing market developments and for making it will bear the loss from risks incurred by decisions to address specific developments. banks with no ability to curtail those risks ex c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 123 Box 1.10 Establishment of a deposit insurance scheme A set of principles has emerged from cross-country however, deposit insurance schemes have tended to evidence on the creation of an effective multifunction be publicly managed and to have noncompulsory deposit insurance system. First, and most important, membership. Fourth, it must be made clear that coverage should be limited so that large depositors, funds to cover bank losses will come principally from subordinated debt holders, and correspondent banks the pool of surviving banks and that taxpayers will are convinced that their funds are truly at risk. This be tapped only in truly catastrophic circumstances. creates strong incentives for a relatively sophisticated Fifth, deposit insurance premiums should be actu- set of depositors to monitor the activities of banks, arially fair for the risks taken by banks, although while at the same time providing assurances of in practice they tend to be lower in many countries. safety for depositors of smaller amounts of savings Sixth and finally, deposit insurers must play an active who generally lack the ability to effectively monitor role in decisions about when and how to resolve a banks. Second, membership in the deposit insur- troubled bank, to minimize the cost of resolution and ance scheme should be compulsory, so that stronger protect the remainder of the deposit insurance fund. institutions cannot select out of the pool when new Evidence shows that banks are less likely to become funds are needed to cover losses by other banks. insolvent when the deposit insurer is responsible for Third, joint public-private management of deposit intervening in failed banks and has the power to insurance schemes has proved more effective than revoke a bank’s membership in the deposit insurance either solely private or public management. In Asia, scheme (Beck and Laeven 2008). ante. Experiences from other countries show not immune to external and internal shocks. that deposit insurance institutions need to A framework for crisis preparedness should have some means to curtail the moral hazard be put in place that consolidates the vari- associated with bank risk taking, sometimes ous existing stand-alone arrangements and involving a supervisory role, to better align blocks, includes financial projection model - their compensation rights (that is, the pre- ing and contingency planning, and involves mium paid by banks) and obligations (pay- all relevant agencies. Strategic design and ments to insured depositors) in the event of capacity building are both key to the success- bank bankruptcy. Otherwise, the advantages ful function of such a framework. of deposit insurance, such as deterrence of reckless risk taking by banks and improve- Recasting the rights and responsibilities of ments in the stability of the banking system government. Most existing problems and by decreasing the probability of bank runs, potential risks in China’s financial system are lost. Second, it is important to provide a can be traced back to the functions of gov- legal basis for deposit insurance institutions ernment. An important distinguishing feature to carry out their duties. The proposed “Reg- of China’s financial system is the extensive ulations on Deposit Insurance” try to solve involvement of the government in financial problems through administrative regulations market activities. As mentioned, the govern- rather than legislation. ment acts as owner and regulator of financial An effective crisis management framework institutions and inu fl ences resource allocation should be put in place. China has come out through direct and indirect controls. The gov- of the financial crises of Asia in 1997 and ernment is also widely perceived as an implicit the recent financial crisis of 2008 largely guarantor of financial institutions. Despite the unscathed. But that should provide no reason perceived advantages of government involve- for complacency, because the Chinese finan - ment and domination in the financial system, cial institutions have been untested and are the negative impact on the financial sector has 124 china 2 0 3 0 become increasingly felt: the conflicting roles since the late 1990s. There are more than a of government in ownership and regulatory dozen types of (quasi) financial institutions functions have made it impossible for regu- under the administration of local govern- lation and supervision to be truly effective; ments. However, supervisory functions for continued patronage of financial institutions, these institutions are scattered across dif- including through appointment of senior ferent departments. Lacking the means and executives, has prolonged the bureaucratic capacity to ensure the safety and soundness culture among banks; and the perception that of local financial institutions, provincial gov - the government will guarantee losses of failed ernments can resort to heavy intervention financial institutions has exacerbated moral in their governance and operations, either hazard, just to mention a few examples. To through the provincial Rural Credit Coopera- establish an effective financial system and tives Union (RCCU) or through the Financial ensure financial stability, China needs to Affairs Office, or Jinrongban . In actuality, reorient the rights and responsibilities of gov- the provincial governments have assumed an ernment in the financial sector. ownership role in local financial institutions, First, the government should put more at the expense of pursuing their regulatory emphasis on creating an environment condu- functions. cive to finance. The government could invest In this regard, there is a need to estab- in financial infrastructure, allow the SFIs lish an effective provincial-level financial to price their services and products without supervisory framework. Local governments interference, promote entry, and impose dis- should focus on exercising their supervisory cipline on failures. A combination of con- responsibilities, maintaining effective coor- ducive financial policies, enabling financial dination with central government supervi- infrastructure, a reasonable degree of compe- sory authorities, and gradually establishing tition, and the threat of bankruptcy will go a regional supervisory capabilities, including long way toward bringing down transactions establishing a supervisory framework, train- costs and providing the right incentives for ing a professional supervision team, and SFIs to step up efforts to provide convenient, strengthening the effectiveness of on-site rapid, and reliable financial services. examination and off-site surveillance. Better Second, the conflict of interest caused by provincial-level financial supervision will not the multiple roles of government as owner, only alleviate the supervision burden of the supervisor, and promoter should be resolved. central regulator but also fill the vacuum and Such conflicts of interest make it difficult for ultimately reduce regional financial risks. To the supervisory authorities to carry out their establish such an effective regional financial roles in a neutral and just manner and thus supervisory framework, local governments to take decisive actions in case of serious should gradually separate the responsibilities offense. Besides, the regulatory authorities of ownership and supervision. in China are deeply involved in the gover- Fourth, the government needs to define nance and operations of financial institutions and effectively provide noncommercial finan - through the power to appoint and remove cial services. A clear line between policy and top-level managers. commercial activities would determine what Third, the rights and responsibilities services and products should be provided of local governments need to be aligned. by the government or by financial institu- Although local governments bear the respon- tions owned by the government. In cases sibility for the failure of local financial insti - where policy-related finance is justified, prin - tutions, they do not have relevant supervisory ciples and policies should be clearly set and mandates and capabilities. Consistent with supported by performance monitoring and the overall trend toward decentralization, the evaluation. An exit strategy is also needed to central government has increasingly granted avoid prolonged use of public resources and authority to local governments, especially potential distortion of credit markets. All c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 125 this will allow commercial financial institu - assets of SOEs is also significantly lower tions to focus on their commercial business, than that of other firms (see the previous improving the effectiveness of capital usage section on enterprise and sector reform). and avoiding both financial and fiscal loss. On the other hand, the average debt to A good understanding of the commercially equity ratio of SOEs is substantially higher, sustainable frontier is essential for further exceeding 230 percent (Liu and Zhao reform in the policy banks and the promo- 2009). If the financial system is liberalized, tion of inclusive finance to rural households many highly leveraged SOEs would face and micro and small enterprises. difc fi ulties in financing their investment or debt at low cost, resulting in deteriorating their financial situation and possibly lead - o bstacles to Reform ing to insolvency. The main obstacles to reform and the diffi - • Political and bureaucratic resistance. culties faced in the process of financial lib - Financial repression has created economic eralization are those commonly found in a rent that has been distributed to favored financial system that has been dominated borrowers and nurtured vested interests. by state-owned banks or where the govern- Banks have enjoyed a comfortable busi- ment has strongly intervened for a sustained ness environment provided by high entry period. The concerns over these obstacles barriers, interest rate control, and excess tend to delay the reforms even as reforms are demand for credit, which allows credit needed to meet the changing internal and rationing. Officials’ power to control external economic environment. banks and their credit allocation is one source of their power over the economy • Moral hazard of state-owned banks and and society. All these would work to enterprises. In a situation where major mobilize resistance to financial reform banks and firms are owned by the state, and build a tendency of system inertia or moral hazard can be pervasive. Without regressing back to the old system. hard budget constraints, firms may con - tinue to engage in reckless investment and Triggers for Change borrowing that would lead to continued high demand for credit despite increased Internal and external forces that build up as interest rates. Banks that put higher pri- their economies grow and expand eventually ority on gaining market share than on lead to financial liberalization and opening. profit and prudential management would This is illustrated by evidence from other drive interest rate competition. Weak countries such as Korea and Japan (annex banks would have especially big incentives 1D). Such pressures from both domestic and to offer higher deposit rates to mobilize external sources will also mount for the Chi- funds and lend or invest them in high-risk nese authorities in the course of transition borrowers or projects. That can lead to from middle-income to high-income status. widespread distress borrowing and finan - The following forces could intensify pres- cial instability. If the strong incentives for sures for change in domestic financial system moral hazard are not properly checked, and drive the initiation of financial sector interest liberalization, and financial liber - reform irrespective of the government’s inten- alization more generally, may invite a high tions over the next one or two decades: risk of financial instability. • Financial weakness of some SOEs. Cur- • Integration in the global market. The Chi- rently, SOEs pay much lower average nese financial system will have to become interest rates for their debt than other more integrated with the international borrowers such as private firms and coop - financial system. China’s rapid past eco- eratives. The weighted average return on nomic growth results from, among other 126 china 2 0 3 0 things, the opening and integration of the become increasingly crucial in sustaining Chinese economy into the global economy. growth. This integration has so far been led by the • External pressure from the global econ- trade and real sectors, and to a limited omy. Relative to the global economy, extent by the financial sector. In transition China’s ascendance toward an advanced to a high-income society, greater integra- high-income economy will be different tion of the Chinese financial sector into from that of the ascendance of any other global capital markets will be inevitable, country in the past. Asian countries that as the business of Chinese firms becomes took off earlier, including even Japan, increasingly globalized and a growing could take the global economy and inter- number of foreign financial institutions national economic system as an exog- penetrates the Chinese financial system. enous variable in the course of pursuing • Possible increase of nonperforming loans their development strategy. In contrast, (NPLs) and deterioration of banks’ bal- the global economy and global economic ance sheets. Without reforms in current system will no longer be endogenous to lending practices and governance struc- the development of the Chinese economy. tures of state-owned commercial banks, In other words, the interplay between the banks are likely to again accumulate China and the world will be a key factor large NPLs if the economic growth rate affecting the nature and pace of China’s slows and the performance of SOEs dete- ascendance to high-income status. In the riorates. The periodic increase in NPLs process, there could be tremendous poten- and repeated requirement to clean up tial for conflict and tension between China bank balance sheets using taxpayer money and the world economy. China is likely to could increase public discontent with the play a major role in writing the rules of government’s heavy regulation and control international trade and finance. It would over the banking system. be hard to imagine that such a country • Demand by the general public. As income would maintain strong foreign exchange levels rise, and as households accumulate and capital controls with frequent inter- greater financial savings, Chinese citizens ventions in the exchange market. will demand a wider variety of financial savings options and asset investments. Sequencing of Reforms The demand for more equal and open access to economic opportunities will also Keeping adequate pace and sequencing will increase. Likewise, as China’s industrial be very important for the successful progress structure and firms become more sophis - of financial liberalization and opening. Chi - ticated and diverse, there will be a grow- na’s financial sector has served the rapid eco - ing need for decentralized monitoring and nomic growth reasonably well over the past governance of firms by market players. three decades, and in the process, it has been International experience indicates that as reformed and restructured. However, in view economies mature, financial services pro - of the current and expected future economic vided through securities markets become circumstances, it should be further reformed increasingly important for firms, particu - and restructured. China may not need to pur- larly those in high-technology industries. sue the same structure (including the own- • Pressure from the real economy. As noted, ership structure) and practices of financial to keep GDP growth at relatively high market as are seen in most advanced econo- levels, China will have to rely more on mies these days. But it is also true that the total factor productivity growth through liberalization and opening process will not be support for innovations and efficiency easy and could face many challenges includ- improvements. More efficient capital allo - ing instability or temporary deterioration of cation through the financial system will economic performance, especially if it is not c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 127 managed carefully. While managing finan - may be more able to resist external pres- cial reforms is as much art as science, and sure, it would still need to accommodate country-specific circumstances figure heavily, demands by the rest of the world to grow certain broad principles for managing reform and prosper together. By liberalizing the can be put forth, drawing on the experience domestic system earlier rather than later, of other countries. and in a systematic rather than piecemeal Reckless deregulation driven by the inter- fashion, China could achieve the benefits ests of the regulated should be avoided, as of financial development without suffering attested to by financial crises of many other undue instability. countries, including the United States and • Financial market infrastructure should be Europe. Liberalization should be comple- strengthened before liberalization. For the mented by strengthened regulation and system to embark on a virtuous cycle, the supervision. On the other hand, too much government will need to strengthen such regulation will choke innovations and infrastructure as quickly as possible and improvement in efficiency. Striking the gradually reduce its inu fl ence in the inter - right balance is not easy but is an essential nal affairs of the financial institutions, consideration. placing its focus on the roles that belong to the government, including regulation and • Financial reform is the result of a politi- supervision, securing credible accounting cal economic process that can limit what and audit practices and transparency in is feasible in the near term and slow prog- transactions, and creating and enforcing ress. Certain market-based reforms can- the right incentives and mechanisms. not be deepened without accompanying • Financial reform can progress successfully measures. Premature reforms may also be only when accompanied by institutional a source of financial instability. The histo - and organizational reforms. Liberalizing ries of both Japan and Korea indicate that market rules without changing old insti- partial deregulation of the financial sys - tutions can deepen distortions. Unless tem led to regulatory arbitrage that ulti- the government’s organization changes, mately proved destabilizing. Deregulation its modus operandi of intervention and thus must be introduced across various involvement in the financial system may sectors in the financial system in ways that not significantly change. This gives the do not lead to major regulatory arbitrage. system strong inertia against real liberal- Banks and NBFIs should be liberalized ization. Again, the Japanese and Korean along parallel tracks, so that a severe dis- experiences are cases in point. In this intermediation or rapid expansion in some respect, in China, the reform of gover- sectors does not take place and become a nance and incentive structures for man- cause for financial crisis later. agement and staff of state ownership • The pace of domestic liberalization must functions and institutional reforms of the be expedited when external opening of relevant government bodies are two high- the financial system is envisaged. While priority agenda items. mounting external pressures eventually forced financial market opening in Japan and Korea, it also led to a significant shift Land Policies of domestic financing toward offshore A Key Factor: Land transactions or to severe financial instabili - ties because of a lack of concomitant prog- Land constitutes a key factor in China’s quest ress in domestic financial liberalization. In for more efficiency-driven economic growth this regard, further interest rate liberaliza- and more balanced and equitable develop- tion should be expedited according to the ment. Over the past three decades, land, principles suggested above. While China together with investment, has fueled China’s 128 china 2 0 3 0 extraordinary levels of infrastructure devel- market for urban land use rights has been opment, urban expansion, and industrial established and advanced since the mid- growth and has contributed to maintaining 1980s, and robust regulations on land tak- social stability. Through its important links ings and compensation are in place. to the fiscal and monetary spheres, land However, previous reforms have left in use has critically affected macroeconomic place a number of problematic policies, stability. The state, especially local govern- institutional arrangements, and implemen- ments, has been skillful in using land, a key tation practices. Additional significant chal - economic resource, to carry out its industri- lenges related to land policy have emerged in alization and urbanization strategies. Fol- the course of rural-to-urban migration and lowing the commercialization of finance, urban expansion. land has also become an important means To transit successfully to high-income to strengthen the links between government status and to realize a harmonious society, and business. Although China seemingly has China will need to make some fundamental some of the most rigid regulations for land choices in land policy to overcome the con- use, land is often used by local governments straints embedded in the current land tenure to motivate investments, but often in a discre- systems and to address the challenges that tionary and distortionate fashion and to the have emerged. Further reforms will have to detriment of rural land rights holders. reduce the complexity and contradictions In the future, a sound land policy, legal inherent in the current system of collective framework, and enforcement mechanisms and state ownership and emerging private will be prerequisites for continued develop- property rights to land and ultimately treat ment and structural changes. More efficient the different types of land ownership and land use will promote TFP and GDP growth, the associated private property rights equally help maintain employment, and ensure Chi- within a clear legal, institutional, and policy na’s domestic food production capacity. Well- framework. Such reforms will also have to set functioning land markets will allow farms to China on a path toward a more market-based grow into units that can raise rural incomes allocation of land resources across rural and and promote efficient and livable cities. Chi - urban spaces, ultimately in the form of a na’s land policy will remain critical for main- unified land market. In parallel, the institu - taining social stability. In the context of rapid tions to support such a market will have to urbanization and migration, rural land will be developed. Over this period, China will continue to serve as a social safety net in hard need to reconsider the state’s unique monop- times. And land, in one form or another, will oly power in the primary land market, which remain an important source of public revenue gives it the sole right to convert land for at local levels. urban use. China will need to allow the state Over the past three decades, China has to be transformed into a market regulator, made impressive progress in reforming and administrator, service provider, and enforcer developing its land-related policy and legal of rules. It will also need to ensure the equita- framework. From the introduction of the ble participation and sharing of benet fi s from Household Responsibility System (HRS) in land management and transactions among its 1978 to the Property Law of 2007 and the citizens. 2008 CPC “Decision on Important Issues In the most general terms, in realizing its Concerning Rural Reform and Develop- vision for 2030, China will have incorporated ment,” a range of policy decisions and legal and adapted the critical benchmarks from reforms has addressed the questions of secu- experiences in high-income countries to its rity of tenure and access to land, particularly specific economic, institutional, and societal agricultural land, and property. (See box 1.11 context. It will have in place a policy and legal for a summary of key milestones in rural land framework that provides clarity on land own- reform.) In urban areas, a well-functioning ership and property rights. It will have open c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 129 Box 1.11 Historical perspective: China’s land-related policy reforms and emergence of the legal framework China’s land policy and legal framework is evolv- forms of compulsory farming implemented through ing continuously in response to economic and social administrative order. changes. Policy directions provide clear evidence of In 1988, the Land Administration Law, modeled a consistent appreciation of tenure security. There is on the Hong Kong Leasehold System, legalized the also a clear trend of embodying policies into laws granting of use rights to state-owned land to private that is moving the country toward a comprehen- users and the transfer of such rights among them. In sive legal framework for land. The main reform 1998, the law was revised to mandate that farmland milestones over the past three decades included the be contracted to households for a term of 30 years. following: In the case of urban land, the revised law provided China’s Constitution provides that land in rural for marketable use rights of up to 70 years and cre- and suburban areas, except for that stipulated as ated the legal foundation for an active urban land state owned, is owned by rural collectives. The rights market. The law set out detailed procedures Household Responsibility System (HRS) of 1978 governing the taking of farmland by the state but introduced the contracting of collective farmland to did not provide for the meaningful participation by individual households for private farming, initially farmers, through such means as prior notification, for a 5-year lease period that was later extended participation in determining compensation, and to 15 years (1984) and then to 30 years (1993). By appeal during the expropriation process. 1983, virtually all arable land had been allocated to The No. 18 Document of 2001 provided further rural households. The HRS laid the foundation for policy direction by prohibiting the collectives from strong agricultural and rural growth and for China’s taking back land rights and recontracting those extraordinary performance in rural poverty reduc- rights to nonvillagers for value. In 2002, these poli- tion in the following decade (Lin 1992; Ravallion cies were embodied in the Rural Land Contracting and Chen 2004). Law. It clarifies the relationship between collec- The Party’s No. 1 Document of 1984 laid down tive land ownership and farmers’ land use rights, the foundation of China’s current rural land rights defines the contents of land use rights, and gov- system. It clarified the separation of collective own - erns the transfer of individual farmland rights. It ership from individual land use rights and stipulated provides that rural land contracting and operation that collective land be contracted to households rights held by farmer households may be transferred for a term of 15 years. It allowed for the voluntary (to other village households), leased (to nonvillage transfer of individual land rights between farmers households), exchanged, assigned, or transacted by but did not provide guidance on land readjustments other means in accordance with law. It also pro- within the collective. The No. 11 Document of 1993 vides legal remedies for any violations. The Property reinforced the HRS. It required that farmers’ farm- Law of 2007, the first comprehensive civil property land rights be extended for a term of 30 years upon code in modern Chinese history, articulates that all the expiration of the initial 15-year lease period. It types of property in China—state, collective, and endorsed transfers of farmland rights for value with private—are entitled to the same level of legal pro- prior consent from the collective and clarified the tection. Furthermore, it characterizes farmers’ rural Central Government’s view that administrative read- land use rights as property rights rather than as the justments in response to population changes would contractual rights defined by previous laws, and it violate famers’ rights. The No. 16 Document of provides greater protection for small farmers’ land 1996 explicitly prohibited large readjustments and rights. It also reaffirms the provisions of the Rural restricted small readjustments through the require- Land Contracting Law. Regardless of the type of ment of approval by two-thirds of the villager assem- land transaction, transfers of use rights must adhere bly or villager representatives and by township and to the principles of voluntariness and free negotia- county government. The document prohibited all tion between transferor and transferee, compensa- (Box continues next page) 130 china 2 0 3 0 Box 1.11 (continued) tion, freedom from compulsion, content and formal rights for all farmers remains challenging. A revi- procedure, specification of contract terms, and a sion of the Land Administration Law was under way requirement that the transferee possesses the capac- (as of 2011) and was expected to further strengthen ity to farm the land. In 2008, the CPC’s “Decision tenure security, clarify the scope of state expropria- on Important Issues Concerning Rural Reform and tions for public interest, determine compensation Development” introduced a landmark change to approaches for land takings, and extend the protec- rural tenure by extending the 30-year term of fam- tion of farmers’ rights to all types of land, including ers’ use rights for an indefinite period. residential and collective construction land. Land policy reform has been significant, but ensuring secure, marketable, and long-term land and integrated land markets that facilitate the 1.12 for an international perspective on land accessibility and efc fi ient allocation of land to policy.) various economic activities. And it will oper- Despite a relatively clear legal and policy ate institutions that are efc fi ient, transparent, framework on rural land tenure, rural house- and accountable and support the functioning holds continue to have weak rights over land of land markets, and it will apply technologies and often face expropriation risks. The result- and skills that support the efficient adminis - ing insecurity creates strong disincentives for tration and governance of land resources. longer-term investments in agriculture and This report outlines three land policy reduces land consolidation and rental activi- themes or issues that will be particularly ties. For example, one survey found that critical for achieving high-income status and farmers who have at least one land document social stability, along with relevant reform are 76 percent more likely to have made mid- needs and options. The three needed reforms to long-term investments than those who involve tenure security in rural areas and had not been issued a document (Landesa governance of collectives; land policy and 2011). Farmers with documents that com- rural-urban integration; and land policy and plied strictly with the law invested even more. municipal finance. Problematic aspects are found in persistent limitations in the tenure rights themselves, specifically with regard to the renewability Tenure Security in Rural Areas and and duration of existing farmland use rights Collective Governance and contracts that have not yet been embed- On its path to high-income status, China ded in the law. Equally important, the defini - needs to improve overall tenure security in tion, protection, and the treatment of rights rural areas to create the right incentives for over rural residential and other collective long-term investments and continued growth land remain incomplete and problematic. in agriculture and for rural-to-urban migra- In addition, serious difficulties remain in tion through effective implementation of its the implementation of policies and laws, in policies of indefinite land use rights to farm - improving governance and accountability at land and strengthening of the rights to other the local level, in the documentation of land types of rural land; expanded land registra- rights, and in citizens’ low awareness of exist- tion and strengthened rural land markets; ing rights. Taken together, these gaps create and reform and modernization of the gover- the potential for abuse of power and corrup- nance structure of rural collectives. (See box tion. Disputes over rural land have become c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 131 Box 1.12 Legal and policy framework: International perspective High-income economies are typically characterized texts of compensation for compulsory acquisition by widespread ownership of and access to land and or expropriation, taxation, and accounting) and for property. Land is one of the most critical produc- defining processes for change of use (through plan - tion inputs and accounts for a large share of national ning, zoning, and land use regulations). As a result, wealth in any given economy. Given the importance associated rights and responsibilities are generally of land and property, high-income economies have considered secure and well defined, which facilitates generally moved toward ensuring clarity of defini - economic activity. While uncertainties in tenure and tion of rights and security of tenure of land and transactions can never be entirely eliminated, they property. Legal definitions and secure tenure have can be made somewhat predictable and be offset by maximized land utility and its potential contribu- risk management strategies, including insurances of tion to economic growth, while minimizing negative various kinds. impacts of state interference and lengthy, unproduc- High-income economies, reflecting in part the tive disputes. Thus, for example, while the ultimate power of the vote and in part that of social groups level of ownership might lie with the state, it has and consumers, typically have well-developed legis- long been established that the state retains in effect lated social policies and codes. Legislative provisions only minimal rights. define basic landlord and tenant arrangements in Constitutional and legal frameworks define basic both housing and commercial sectors. Similarly, leg- ownership and how this may be given effect with islated and regulated environmental policies defin - regard to alienation, inheritance, divorce, mortgag- ing restrictions and responsibilities significantly ing, and the like. Registration and cadastral admin- influence how land and property may be used and its istrations record and thus further define these rights value. Increasingly, social and environmental safe- and parcels, covering an increasingly wide range of guards are conforming to international standards tenures and rights. Legal frameworks also define the and codes of practice, facilitated by international bases for defining values (for example, in the con - forums, conventions, and agreements. more frequent, for example, in cases where document in this regard. Near-term reform is returning migrants want to resume farming expected to anchor the provision of indefinite and are claiming back their leased-out land. household rights to farmland, as articulated About one-quarter of villages across China in the policy, in the relevant laws. The reform is estimated to have been subjected to land toward indefinite land use rights will need to consolidation and leasing arrangements to clarify who will be eligible for such rights, for commercial enterprises, a recent and not yet example through determining farmers’ land- well-understood phenomenon. rights-related membership in a collective. This complex set of problems needs to be In the near to medium term, supplemental addressed in a carefully sequenced and inte- reforms will have to tackle the poor quality grated set of reforms that strengthens tenure of current documentation on collective land security in rural areas, likely involving the ownership and individual use rights. These following elements: reforms could promote the introduction and implementation of a land certificate and con - Securing indefinite land use rights. Use tract system that not only specifies the prop - rights to cultivated land need to be secured erty itself but includes core legal provisions by expanding the renewability and duration and rights and responsibilities as well as sanc- of existing 30-year land use contracts and tions in case of violations. Land contract and certificates. The CPC 2008 Policy Decision, certificate documentation needs to be harmo - with its stipulation of indefinite land use nized across the rural and urban spheres, for rights to agricultural land, was a landmark example, by following the standard format 132 china 2 0 3 0 of China’s existing urban land use rights The functioning of markets for farmland certificate. serves as an important benchmark of tenure security. During the 1980s and mid-1990s, Improving land registration. China and less than 5 percent of cultivated farmland most other developing countries lack a reli- in China was being planted under rental able complete national inventory of land par- tenancy (Li 1999; Brandt and others 2002). cels. While the full establishment of a national Since the mid-1990s, rental markets for culti- land inventory may not be feasible in the short vated land have developed in a more vibrant or medium term, effective implementation of way. Although little systematic official infor - land rights will require some degree of clarity mation is available, recent surveys provide about the location and extent of the land to some evidence of the expansion of the rural which the rights apply. More reliable, precise, land rental market. The share of cultivated and accessible records concerning the location land being rented was only 7 percent in 2000 of individual land parcels and who has what but increased to 19 percent in 2008, accord- rights to a given parcel will help strengthen the ing to a survey conducted by the Center of trust and sense of security of contract owners, Chinese Agricultural Policy in 2008. More help reduce land disputes, and facilitate the land is being rented out in coastal and south- more efficient implementation of land-related ern China than in inland areas or northern laws. China. A DRC survey in 2007 covering The government has recognized the role of almost 3,000 villages found that 21 percent land registration in promoting tenure secu- of cultivated farmland had entered the rental rity, rural growth, and rural-urban migration market. In Anhui and Shandong, land turn- and has already piloted various land informa- over ratios were 12.4 percent and 6.1 percent, tion management systems and methodologies. respectively (World Bank 2010b). Most of the In the near term, the registration of farmland current transfer activities are informal trans- needs to be scaled up to realize its broader actions and, in the absence of enforceable benet fi s. Significant start-up investments will contracts, have led to inefficient and narrow be required to pursue the systematic and free market segmentations where sanctions can initial registration of farmland. Ultimately, as be enforced informally. international experiences show, land registra- The transition to efficient markets for tion can be self-financing through fees for farmland rights over the coming decade will secondary transactions. Lessons from other be complex and difficult. The development countries indicate that administration of the of appropriate market institutions will need land registry under a single agency could be to proceed in parallel with complementary one favorable option, because it avoids over- reforms, including household registration lapping jurisdictions and parallel systems and reform, promotion of labor mobility and approaches. Over time, land registration and expansion and access to social security sys- the issuance of standardized rights certifi- tems. In due course, tenure security to other cates will gradually have to be extended to all types of collective land and their marketabil- types of rural land. ity will have to be strengthened in similar ways. (For an international perspective on Developing rural land markets. The transi- land institutions, see box 1.14.) In the lon- tion to transparent and efficient markets for ger term, rural land use rights holders need farmland use rights will be important to pro- to be given access to the urban land market mote productivity and GDP growth and to and become full participants in the sharing address China’s rural-urban income gap. (For of benet fi s whenever rural land is being con - an international perspective on land markets, verted to nonagricultural purposes. see box 1.13.) Gains in productivity of land use through land rental in a growing econ- Reforming the institution of the collec- omy, such as China, can amount to 60 percent tive. The relatively low security of land ten- (Jin and Deininger 2009). ure is part of a larger grassroots governance c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 133 Box 1.13 Land markets: International perspective One key pillar of economic development in high- land market. In addition to the different use s ectors, income countries is the existence of efficiently func - separate markets reflect the diversity of tradable tioning land markets. All economic activity requires property rights, including freehold (or “full” owner- access to land. Land markets facilitate accessibility, ship), strata title, fractional title, timeshare, lease- which allows land to be used in the most economic hold, and other property-related rights such as way, thus increasing economic activity and prosper- quotas, carbon rights, and transferable development ity. Prerequisites for an efficient land market include rights. clear land policies, an appropriate legal framework, Efficient land markets depend upon buyers, sell - secure land rights, capable institutional and pro- ers, professional advisers and other intermediaries fessional services, transparency and availability of having access to information. In developed coun- information, and easy access for all. tries, public sector land administration systems Land transactions are often complicated, register transfers of ownership and transfer prices because of the complexity of the property rights and make them available for public inspection. being transferred, the amount of money involved, In addition, data on transactions is usually pub- and the regulatory framework within which the lished through national statistics offices. With the transactions take place. In the United States and the recent growth in e-governance, the trend is toward United Kingdom, sales by private contract (that is, improved web-based access and electronic public for a price agreed directly between seller and buyer) services in analyzing and disseminating data on are by far the most common form. There is no single property transactions. dec fi it. The unresolved opportunities for abuse members of the collective; it will also have of power and rent seeking of village cadres at to clarify the relationship between collec- the expense of the members of the collective, tive ownership of land and individual rights for example in practices of land readjustment to land in view of the government’s push for or commercial development, and the rela- a transition toward stronger and indefinite tive absence of transparent and accountable individual property rights. Such reform will governance structures at the rural collective not only require the strengthening of gov- level, point to larger problems in the relation- ernance at the collective level but involve a ship between the collective entity and individ- fundamental redefinition of the remaining ual land use rights holders. Although recent functions and roles of the collective entity as surveys point to a reduction in the frequency its responsibility for land management may of such reallocations, every village surveyed no longer be relevant. experienced at least one partial reallocation, on average, during the period 1998–2008 Land Policy and Rural-Urban (Wang, Tao, and Man 2010). Integration A key policy challenge in rural areas of China in the coming two decades is how On its path to high-income status, China to modernize the institution of the rural needs to introduce fair and transparent rural collective to keep it relevant and consistent land acquisition policies and practices, cur- with the evolving shifts in law and policy, tailing the role of the state in land requisition, specifically the transition from the original and ensure more socially compatible rural- land use rights contracted for a specified urban integration by allowing collectives and term under collective administration toward land use rights holders to share the benefits indefinite, inheritable, and transferable indi - from urbanization. vidual property rights to land. Reform will The government promotes urbaniza- need to clearly define the nature of collective tion and rural-urban integration as part of ownership and unambiguously identify the China’s overall development strategy. But 134 china 2 0 3 0 Box 1.14 Land institutions: International perspective To work efficiently, land markets must be supported tion purposes and the extensive use of private sector by a wide range of institutions. In high-income econ- firms by the Ordnance Survey, the national mapping omies, institutional development has progressed agency. alongside economic development as a means of deal- Enforcement of laws and regulations is primarily ing with the complexities of land administration, a state function. Each country has its own unique management, and markets. The list of institutional and hierarchical court system. In many developed stakeholders involved in well-developed land mar- countries, these institutions are supplemented by kets is long, ranging from policy makers to bro- special courts and tribunals that deal with spe- kers, mortgage lenders to lawyers, and valuers to cific areas such as land acquisition, taxation, and registrars. accounting. For example, in England and Wales, Government institutions provide the policies, the Lands Tribunal determines disputes about com- laws, and regulations governing all aspects of land pensation payable to owners and occupiers of land use. Their interaction is often complex, with func- affected by expropriation, while independent Valu- tions divided between ministerial departments and ation Tribunals have jurisdiction over annual prop- different levels of government. These functions erty tax appeals by taxpayers. In addition, many include land-use planning and enforcement, the countries have developed dispute resolution systems implementation of property taxation, management that take place outside of court. These are usually of state-owned land, and land registration. In recent administered by recognized independent profes- years, there has been a trend toward commercial- sional bodies, such as the Royal Institution of Char- ization, with government institutions operating as tered Surveyors in the United Kingdom. “agencies,” outsourcing service provision to the pri- Competent, reliable, and accessible professional vate sector and entering public-private partnerships. services provide an essential link between buyers, These innovations have been driven by the demand sellers, and government institutions active in land to cut costs, improve accountability, increase accessi- markets. In addition to bankers and financial service bility, and enhance capacity. Examples in the United providers, these include lawyers and conveyancers, Kingdom include the Valuation Office Agency, brokers or estate agents, valuers, land surveyors and which is responsible for valuing properties for taxa- structural surveyors, accountants, and others. China’s land tenure system remains biased surpluses supported the initial stages of toward urban development at a time when industrialization. But these features, which the rural-urban income gap has widened to are highly unusual in comparison with levels rarely observed in other countries. The those in high-income economies, are now land tenure system also remains character- less advantageous to China’s development ized by the strict separation and different and a major obstacle to a harmonious rural- treatment of rural and urban land. Within urban integration. The widening rural-urban this separation, the state’s exclusive power income gap, widespread land-related social to acquire rural land and transfer it to urban conflicts caused by this separation, and other users favors the currently uncontrolled and serious problems put this feature of the pres- often inefficient pattern of urban develop- ent land tenure framework and policy into ment. The resulting land acquisition practices question. seriously disadvantage both the collective and The persistent duality of rural and urban the rural land use rights holder in sharing in land systems needs to be managed and ulti- the appreciating value of land entering the mately phased out. Various pilot efforts at urban market. the local level throughout China have experi- These practices were historically deter- mented with rural-urban integration efforts mined and were justified in the early years with a view to developing a more comprehen- of China’s development when agricultural sive policy reform framework in the future. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 135 Box 1.15 Rural-urban integration and “linking mechanisms”: Current and emerging issues (discount factors apply to account for differentials in In contrast to farmland use rights, Chinese laws do land quality). This unit of reclaimed farmland cre- not extend the same level of protection to farmers’ ates one unit of construction land quota that can be residential land or other collective land, such as col- applied elsewhere in the jurisdiction. At this “some- lective construction land. In 1962, when China’s where else” place, usually the peri-urban areas where agriculture was still collectivized, residential land the urban land market price is high, the government was allocated to farm households to use “for a long can convert one unit of farmland to nonagricultural time without change,” creating a de facto individual use and grant use rights to this new nonagricultural property right to residential land. The limited legal land to developers. protection of rural residential land is a major disad- Through this mechanism, currently nontransfer- vantage for farmers in the land conversion process. able rural residential land rights can be made mar- The legal vacuum has allowed many opportuni- ketable. However, because the rights pertaining to ties for experimentation and policy pilots that can residential farmland and collective construction infringe on farmers rights and contradict and cir- land are so weak, local governments have targeted cumvent Chinese laws. these lands for expropriation and revenue genera- Local governments throughout the country are tion, while developers have sought them for urban pursuing a range of programs aimed at promoting construction. While local governments often classify urban-rural integration. These programs often tar- such “exchange” of farmland rights as voluntary get farmers’ rights to farmland and residential land land rights transfers, it can in fact constitute illegal through an approach of “exchanging farmland rights appropriation of land rights. for social security coverage and exchanging residen- More important, forcing farmers to give up their tial land rights and houses for urban apartments.” property rights to land in exchange for social secu- Initially put forward in 2004, these so-called rity coverage also poses a moral dilemma because linking mechanisms involve the reclamation of rural urban residents are not required to make a similar (collective) construction land, including farmers’ res- exchange. This practice also contradicts the inten- idential land for conversion to farmland. Every unit tion of the Property Rights Law (2007), which of land, reclaimed corresponds to a reduction of one requires that all type of property rights enjoy the unit of rural construction land, and to an increase same level of legal protection. of one unit of farmland within a given jurisdiction Many of the pilots have brought new chal- the scope of this power is unusually wide by lenges to the surface and often have created international standards, and its use has been their own problems (box 1.15). very extensive. During 2003–08, a total of To promote a more harmonious integra- 1.4 million hectares of agricultural land, of tion of rural and urban areas and citizens, which about 950,000 hectares were cultivated two fundamental reforms need to be pur- land, are estimated to have been requisitioned sued: the reform of China’s current rural land under current laws, while an additional requisition policies and practices is a pressing 450,000 hectares are reported to have been short- to medium-term issue; and integration requisitioned illegally during the same period. of rural and urban land markets is required The impacts of compulsory land requisition for more equitable benet sh fi aring in the lon - have not been isolated and relatively localized ger term. as they might be in other countries. The pro- cess of land requisition needs serious reform Reforming land requisition and compensa- in three dimensions. tion practices. Across the world, govern- First, Chinese law does not explicitly ments have the power to acquire land on a limit the purposes for which the state can compulsory basis in certain circumstances use its power of compulsory acquisition. In and subject to certain conditions. In China, contrast, no high-income country allows its 136 china 2 0 3 0 government to use compulsory acquisition as In the near term, reforms of the requisition the normal means of assembling land for pur- process need to introduce key provisions such poses that are clearly commercial or indus- as advance notice, provide the opportunity trial in nature. In the near term, to be more for consultation and participation during the in line with international practices, tighter requisition process itself, and put in place constraints on the use of state’s power for workable channels for appeal and dispute land requisition will need to be clarified in resolution. the legal framework and implemented along the overarching principle that government’s Integrating land markets for equitable ben- taking powers are extraordinary powers that efit sharing. China’s long-term land policy should be limited to meet public needs that vision needs to consider more broadly how are not well addressed through the opera- to rebalance the relationship between the tion of the market. Such reform needs to go state’s monopoly in the primary land market hand in hand with allowing the emergence and the collective and farmer participation in of market mechanisms that span the urban- the conversion of agricultural land. Measures rural divide. to decrease the urban-rural gap will have to Second, current practices of compensation consider fairer benefit-sharing approaches for requisitioned land need to be reviewed through, for example, gradually granting because they are a frequent cause of com- access for collectives or rural land-use-rights plaints about unfairness in the land requisi- holders to participate in the transfer of rural tion process. These are based on agricultural land to the urban land market, while at the output value but do not consider the value of same time reducing and ultimately phasing the land in its eventual urban use. The stan- out the state’s monopolist power in the pri- dard for compensation of cultivated land is a mary land market. multiple (generally the duration of the land Experiences for successful rural-urban use contract, that is, 30 years) of the annual transitions and integration process exist, for agricultural output averaged over three years. example in Taiwan, China, and Korea. Both This practice is problematic in a context economies were able to make farmers’ land where the differential between urban and rights secure and free from administrative rural incomes and livelihoods is so large, and intervention. That enabled farmers to invest where this differential is reinforced by the in land, resulting in much increased land pro- separation of rural and urban land markets. ductivity, and to benefit from investments A rethinking of the compensation practices, in urban development. In both economies, particularly where land is requisitioned for urbanization took place against a back- commercial purposes, is needed. It is rec- ground of small farms with low per capita ommended that the government consider landholdings. Both economies adopted a international practices, where compensation farmer-friendly approach to the conversion of is usually based on the market value for the farmland for nonagricultural use and intro- best possible use. duced comprehensive measures that let farm- Third, shortcomings in the land requisi- ers capture a share of the increased land value tion process itself need to be addressed. While as a result of conversion. In both econo- the laws set out the procedures for the taking mies, farmers who sold their land rights and of agricultural land by the state and require found employment in the city were automati- local government to make the resettlement cally covered under urban social benefits. In plan public and to receive comments on it, China, land requisition and urban expansion these steps often take place only after the req- have not only limited farmers’ proceeds from uisition has been approved. In addition, there their land assets but also led to an erosion is no explicit requirement that collectives or of rural land rights by excluding collectives farmers be advised of the requisition ahead and farmers from the urban land market. of time and be given an opportunity to react. A comprehensive reform program to better c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 137 safeguard rural land ownership and, even accounts for the “public good” element of more importantly, individual land use rights land converted to urban uses. Alternatively, for farmland and residential land, in the pro- the zone expropriation model practiced in cess of urban-rural integration needs to be Taiwan, China, or Korea’s experiences with put forward. rural urban integration may offer valuable Across China, several reform pilots are lessons on how to rationalize urban and currently under way, most prominently in industrial planning with fair participation Chongqing and Chengdu. These pilots are and benet fi sharing of the rural population in experimenting with rural-urban integration the development process (box 1.16). approaches and promote the registration and definition of rural land ownership and prop - Addressing the urban village problem. The erty rights, the development of policies and move toward a unified market for construc - mechanisms for the transfer and marketing tion land needs to be carefully sequenced. of rural construction land for urban develop- One option would be to begin in urban areas ment, policies for the protection of farmland, where collective land ownership is still wide- and labor mobility and social protection spread in the form of “urban villages”; col- reforms, as well as other elements. While the lectively owned land is generally construction lessons and experiences of these pilots are land that was not requisitioned by the state to be collected and carefully evaluated over when it requisitioned land for city expansion. the coming years, the broader reform direc- Because of the much higher compensation tions for making the rural-urban integration cost for collective construction land than for process more equitable could embody the agricultural land, collective construction land following: remains scattered throughout many urban areas in China. The persistence of urban vil- Curtailing the state’s land requisition lages is one cause for inefficient city develop - and opening the market for construction ment and urban sprawl. Allowing collectives land. As noted, the state’s power and scope in urban areas to trade their collective con- for compulsory acquisition needs to be struction land in the primary urban land restricted to a more narrowly defined “pub - would likely lead to more efficient develop - lic interest.” This restriction will need to go ment and to higher density land use in urban hand in hand with the gradual introduction areas. of a unified market for construction land. In such a market, collectives and individual Strengthening checks and balances in land-rights holders would participate on an urban development planning. The transi- equal basis with the state in the conversion tion toward a unified urban land market and trading of collective construction land in will require a strict and enforceable imple- the primary land market without first con - mentation of urban and industrial land use verting the land to state ownership. Over planning. While a relatively rigorous urban the longer term and within a framework of planning process is in place, implementation approved and enforceable urban development and enforcement of long-term master plans and land use plans, collectives and individ- is weak. In addition, there is no system for ual holders of land use rights could also be considering the long-term interests of urban empowered to participate in the conversion residents or to hold decision makers respon- of collective farmland to nonagricultural sible for the social and environmental conse- purposes and be allowed to sell and buy land quences of urban development decisions. The use rights across the rural-urban divide and weakness in checks and balances in the cur- benet f fi rom it. rent urban planning system may be overcome The capital gain accruing to collectives or by opening the planning process for public individual holders of land use rights could participation and scrutiny and transparency be subjected to a tax to be set at a rate that through mass media. 138 china 2 0 3 0 Box 1.16 Land policies to promote rural-urban integration in Korea remaining in place. First, half of the total investment Tenant farming predominated in the Republic of by the corporation must come from farmers or farm Korea before World War II. After the war, a massive families and more than half of the executive board land reform was conducted to distribute to former must be farmers. tenants the land purchased from Korean landlords One of the important mechanisms adopted in or confiscated from the Japanese. As a result, more Korea’s urbanization process was its land readjust- than 1.5 million farm households received land, and ment program launched in 1966. Upon the des- the farm ownership rate was raised from 13 percent ignation of the project site agreed by 80 percent to 71 percent. of owners of affected land, about 40 percent of To avoid social disruption in the course of urban- the assembled land will be used by government to ization, Korea took a series of legal and policy mea- develop infrastructure and finance such develop- sures to prevent large-scale farming. During most ment. The remaining 60 percent of the developed of its period of urbanization, tenant farming was land is then distributed to participating landown- prohibited. This ban was eased in 1986 when the ers in proportion to their land contribution to the farming population dropped to less than 35 percent project. These landowners may choose to sell their of the total population. The average farm size rose value-added land or use it for other commercial uses. from 0.9 hectares in 1970 to just over 1.3 hectares More than half of built-up areas in Seoul and over in 1995. Korea also prohibited corporate ownership 40 percent in Pusan were developed through such of farmland and corporate farming. This prohibi- land readjustment projects. tion was lifted only in 1990, with two restrictions Land Policy and Municipal Finance the state’s power to expropriate rural land and its monopoly in the urban land market, Reform and the practice of evaluating local officials On its path to high-income status, China by their contributions to high GDP growth needs to address the distortions in its munici- focus on generating high GDP growth, has pal governance and finance system and encouraged local governments to generate reduce its excessive reliance on land-transfer- additional income from land transfer fees. based revenue generation through the intro- Local governments have also become duction of property taxes and reform of land increasingly reliant on mortgage loans, using requisition practices. requisitioned land as collateral, through the China’s land policy and municipal gover- vehicle of land banks. The practice of land nance and finance systems are closely inter - banking by public entities created under related, and both are shaping the country’s local governments has grown phenomenally urban land use and form for generations to in recent years. Land banks can mortgage come. Both the spectacular achievements as the land they hold to state banks and invest well as the enormous challenges in the area of the loaned funds in urban development. The urban planning and development grow out of aggressive requisitioning of rural land to gen- the country’s decentralized governance struc- erate local revenue is risky and is contributing ture and fiscal systems. to unsound forms of urban growth, unsus- In 1994, China adopted a tax-sharing tainable local finance, and inefficient use of system that provides separate tax collection land resources. powers for the central and subnational gov- ernments. This system has left many munici- Introducing market-value-based property palities with a mismatch between local taxes. Income from land transfer fees has revenue and responsibilities for public service become a significant source of local public rev - provision. In this setting, the combination of enue, and real property in China is subject to c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 139 a range of minor fees, taxes, and charges, but rates at relatively low levels, the initial take there are virtually no annual taxes on prop- from a property tax would probably fall well erty. Over time, property taxes could provide below these averages. For this reason, local a sustainable substitute as receipts from land governments will also have to reduce their trading are reduced in parallel with a reform dependence on revenues from land use rights of land requisition practices. Property taxes in a gradual fashion. are often one of the few major good sources of Implementation of a property tax is a com- revenues for local governments and could in plex task, and even in well-established sys- principle allow the cancellation of a range of tems, significant reforms are often required. difficult-to-collect “nuisance taxes” that can International experience provides guidance be harmful to the local business climate. on the necessary preconditions for effec- However, the property tax will take time tive implementation, such as the existence to grow into a significant revenue source. of adequate technical expertise for property Even in the long run, it is unlikely to fully assessments as well as the administration replace income currently generated by sale of of appropriate land records (box 1.17). The land use rights. Bahl (2009) notes that only a development of such institutional capacity few countries like the United States and Can- could begin in the near term. Political under- ada raise on the order of 3–4 percent of GDP standing and will are critical preconditions if from such a tax, with the developed-country the substantial challenges of implementing a average being 2.1 percent of GDP. Among highly visible and difficult-to-evade tax are to developing countries, the average collection be overcome. The introduction of property is only 0.6 percent of GDP, with only a few taxes should be coupled with a simplifica- countries (such as Uruguay) raising as much tion of the overly complex current system of as 1.0 percent. Because the introduction of a property-based fees and taxes to ensure that property tax is institutionally complicated, these taxes fulfill their particular purpose and because difficulties in establishing initial and do not have an adverse effect on the real valuation would also argue for setting initial estate market. Box 1.17 Land valuation and taxation: International perspective Most modern land administration systems include a Most developed countries impose property significant valuation and taxation function. Public taxes—usually transfer taxes, estate duties, and sector valuations are required for a variety of pur- annual property taxes—based on actual sale prices poses, including property taxation; purchase, dis- or assessed market values. Market value is generally posal, and rental of state land; and assessment of fair considered to be a fair and equitable basis of taxa- compensation where land is acquired through expro- tion. In the United States and Europe, taxes on land priation. An efficient land market, including easy and property provide a cornerstone of municipal access to reliable market data, provides the platform finance. They have the advantage of being widely for transparent and accurate market-based valua- accepted by the taxpayer and are sustainable, pre- tions. High-income economies have well-developed dictable, and tend to provide a hedge against infla - public and private sector valuation professions using tion over time, thus ensuring revenue maintenance internationally recognized methodologies and stan- in real terms. Over the past two decades, technol- dards. Valuers increasingly benefit from advances in ogy developments have made electronic billing and information-technology-based automated valuation payment a central feature in both local and central models, which particularly lend themselves to the government financial management. mass appraisals required in countrywide land tax assessments. 140 china 2 0 3 0 Effectively regulating land banking. China are devoted to prot m fi aximization and secur - needs to review the extent to which land ing land-backed loans. There is no national banking has moved away from what was law or national regulation on land banking, arguably its original purpose, namely, to serve although the practice is referred to permis- as a planning tool devoted to the timed and sively in some government documents. More targeted release of surplus government land effective regulation is urgently needed because in support of overall planning objectives. land banking practices may be of a sufficient Today, land banking is too often an unde- scale across the country to have serious impli- sired conduit for requisitioned lands that are cations for the economy generally, and for the slated for disposal through auctions, which financial sector in particular. Annex 1A Why Did China Grow So Fast? A wide range of factors contributed to Chi- institutions from the more advanced coun- na’s rapid growth. These can be viewed tries and thereby innovate and upgrade its from three different perspectives: “growth industry at low cost and risk (Lin 2010). accounting”; a review of exogenous fac- Lee and Hong (2010) find evidence that tors that favored growth; and a discussion such forces were at work. of the role of domestic policies and physical • A high initial level of distortions. The investments. Chinese economy of 1978 was heavily First, China’s growth performance distorted by previous policies that played reflected strong contributions from labor and to the country’s comparative disadvan- capital accumulation as well as total factor tages. To achieve its aim of developing productivity (TFP) growth. Favorable demo- large, heavy, and advanced industries, the graphics, especially during the early reform government was forced to protect such period, generated a large “dividend” in the activities through various distortions, form of a labor force that grew faster than including suppressed interest rates, low the overall population. Second, very high input prices, and an overvalued exchange and rising investment rates, supported by rate (Lin 2010). This left a sectoral and even higher and more rapidly rising savings spatial misallocation of resources, as well rates, allowed rapid capital accumulation. as a closed economy with limited links Over time, a gradual decline in the labor to the rest of the world. While negative contribution was broadly compensated by in their own right, such distortions also the effect of a rising investment rate. Third, create greater scope for increases in TFP by World Bank staff estimates, TFP growth through policies aimed at their removal. (including the contribution from improve- • A supportive external setting. The global ments in human capital and factor realloca- environment for much of this period tion) remained in the range of 3– 4 percent (Vincelette and others 2011) and the a year, which is exceptionally high by world structural shift to more globalized forms standards. of industrial production (Yusuf and Second, China’s rapid growth was sup- Nabeshima 2010) both worked in China’s ported by three broad sets of exogenous fac- favor as it pursued a strategy of open- tors. These were: ing to the rest of the world. This process included China’s accession to the World • The potential “advantages of backward- Trade Organization (WTO) in 2001 and ness.” Under the “opening-up policy,” associated changes in tariffs and other China was able to borrow technology policies, as well as a gradual opening to and models for social and economic foreign investment. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 141 Third, and most important, China was important contributors included improved able to exploit these favorable conditions macroeconomic management, factors sup- to generate rapid growth by implement- porting a high saving rate (the combined ing a stream of pragmatic, market-oriented effect of rapid productivity gains, contained reforms, and by deepening domestic market wage costs, and a managed exchange rate on integration through improvements in infra- enterprise prot fi ability, with buoyant revenue structure and logistics. Landmark reforms growth and contained current spending on include the introduction of the household government savings), and strong subnational responsibility system in agriculture, the government-led interregional competition to opening up of the tradables sector beginning attract investment. Improved policies and the with the establishment of special economic sustained reallocation of factors to higher zones, extensive price liberalization, deep productivity uses helped keep the marginal reform of the fiscal system, restructuring product of capital high despite a high and and privatization of state-owned enterprises, rising investment rate (Bai, Hsieh, and Qian promotion of the private sector, and reforms 2006; Song, Storesletten, and Zilibotti 2009). associated with WTO accession. Other Annex 1B China’s Industrial Policies: Key Actors and Defining Characteristics China’s industrial policy interventions are Commission (NDRC), the Ministry of Indus- currently implemented by three broad classes try and Information Technology (MIIT), and of actors: high-level national bodies, central others. For example, the “Guiding Catalogue government departments, and subnational of Industrial Structure Adjustment” and (provincial and local) governments and their “Catalogue of Industries for Guiding Foreign departments. In turn, they are influenced by Investment” periodically issued by the NDRC other stakeholders, such as industrial associa- are comprehensive policies, identifying indus- tions and firms themselves. tries to be “encouraged,” “restricted,” or The main high-level bodies include the “prohibited.” The NDRC also issues indus- State Council, the National People’s Con- trial policy guidance for specific sectors. For gress (NPC) and the Communist Party of its part, the MIIT has formulated “Opinions China (CPC). The State Council can issue on Promoting the Merger and Reorganiza- comprehensive multisector documents or pol- tion of Enterprises,” which was released by icy guidance for a single sector, with the aim the State Council in 2010. The role of sub- of promoting a particular structure across or national authorities and their departments is within industries. Laws enacted by the NPC discussed in the main report. can include elements of industrial policy with Currently, China’s industrial policies have significant impacts on certain industries. seven defining characteristics: Finally, “work reports” to various national congresses of the CPC have included impor- 1. They are scale-oriented, that is, they are tant strategic guidance (for example, on the focused on the development of larger selection of “pillar industries”), which has enterprises. For example, in 1993, the laid the ground for follow-up implementation central government announced a strate- measures. gic restructuring of state-owned enter- Several central government depart- prises, including through establishment ments release related policies in accordance of large-scale enterprise groups. In with their responsibilities. These include 1997, the 15th National Congress of the the National Development and Reform CPC issued the “Restructuring Major 142 china 2 0 3 0 Enterprises and Relaxing Control over 4. Policies to encourage technological Smaller Ones” strategy to develop large- advancement have had industrial policy scale enterprise groups. Since 2000, “ful- dimensions. Such policies have included filling large enterprise group strategy requirements to use specific local technol - in key industries” became a central ele- ogies; for example, one large mobile tele- ment of China’s industrial policy. Specific communications operator was required instruments include formulating a scale- to use the indigenous TD-SCDMA 3G oriented industrial development plan and technology. Some such technologies have establishing examination and approval scale economies that preclude their use by conditions that limit entry while favoring smaller producers, thus tilting the playing large incumbents (Jiang and Li 2010). field toward larger firms. 2. They have sought to control the expan- 5. Industrial policies have relied heavily sion of sectors deemed to have excess on direct administrative intervention capacity. As early as the 1980s, when the to shift resources from prohibited to basic thrust of policies was the promo- preferred sectors. While market mecha- tion of industrial expansion, some sectors nisms also play a role, the authorities were already identified as having excess often use very direct means to “close capacity; these sectors included textiles, down, suspend operation, merge and automobiles, and home appliances. In shift” resources. These have included the 21st century, curbing the develop- market access controls, project examina- ment of industries with excess capacity tion and approval, land supply approval, has become a central pillar of China’s loan approval, industrial guidance industrial policy, especially in periods of catalogue, and compulsory elimination macroeconomic adjustment. Since 2007, of outdated production capacity. sectors targeted by the State Council as 6. They have often featured joint action by “controlled industries” included iron and many government divisions. For exam- steel, textiles, aluminum, coal chemicals, ple, the September 2009 “opinions on flat glass, caustic soda, cement, solar poly - inhibiting excess capacity and redundant silicon, shipbuilding, chemicals, solar, construction on some industries to guide and wind power. In such sectors, new the healthy development of industry” entry can be restricted, capacity expan- was jointly promulgated by 10 central sion projects might not be approved, com- ministries and commissions. It required panies can face prohibitions on financing joint action by departments for indus- through corporate debt and initial public trial management, quality management, offerings, and outdated production capac- investment management, environmental ity can be targeted for elimination. protection, land management, finance 3. They have aimed to concentrate sectors management, and local governments. deemed to be too fragmented. During 7. These policies have been pursued at each the 11th five-year-plan period, the gov- level of government, often at cross pur- ernment vigorously encouraged stron- poses. For example, while the central ger enterprises to acquire weaker firms government may aim to consolidate a sec- and took other measures to encourage tor nationally, each province may seek to concentration. Subsequently, documents make this sector a “pillar industry” for from the “restructuring and revitalization its own economy. With over 30 provinces plans of ten industries” have all noted the and many more subprovincial authorities need for “enhancing industrial concentra- involved, the degree to which a particular tion.” Some provincial governments have sector is ultimately favored or discour- in turn used such resolutions as a policy aged becomes hard to discern. foundation to promote a similar concen- tration of their own sectors. c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 143 Annex 1C Unbalanced and Incomplete Financial System Although quantitative measures of financial and insurance companies have grown, they depth seem to indicate that for the most part are dwarfed by the banking system. The China’s financial system is on par or even banking system itself is unbalanced, with the ahead of its economic development, the finan - state-owned large commercial banks hold- cial system is still unbalanced and incomplete ing over half of banking sector assets (table (figure 1C.1). Although securities markets 1C.1). While that share has been declining, FIGURE 1C.1 Select indicators of financial sector size/depth, 2009 a. Bank credit to private sector b. Stock market capitalization CHN CHN 0 0 56 78 9 10 11 12 56 78 9 10 11 12 Log of GDP per capita Log of GDP per capita c. Government bonds outstanding d. Nongovernment bonds outstanding 200 200 180 180 160 160 140 140 120 120 100 100 80 80 60 60 40 40 CHN 20 20 CHN 6 789 10 11 12 67 89 10 11 12 Log of GDP per capita Log of GDP per capita e. Life insurance penetration, premiums f. Non-life insurance penetration, premiums 12 6 10 5 8 4 6 3 4 2 CHN 2 1 CHN 0 0 6 789 10 11 12 67 89 10 11 12 Log of GDP per capita Log of GDP per capita Sources: WDI, IFS, BIS, AXCO. % of GDP % of GDP % of GDP % of GDP % of GDP % of GDP 144 china 2 0 3 0 TABLE 1C.1 Share of banking sector assets by type of bank Percent Institution 2003 2004 2005 2006 2007 2008 2009 2010 Large state-owned banks 58.03 56.91 56.06 55.12 53.25 51.03 50.89 49.2 Policy banks 7.68 7.63 7.82 7.90 8.13 9.05 8.82 8.0 Joint-stock banks 10.70 11.54 11.92 12.38 13.78 14.12 14.96 15.6 City banks 5.29 5.40 5.44 5.90 6.35 6.62 7.21 8.2 Rural banks 0.14 0.18 0.81 1.15 1.16 1.49 2.37 2.9 Rural cooperatives 0.73 1.06 1.23 1.61 1.62 1.6 Urban credit cooperatives 0.53 0.57 0.54 0.42 0.25 0.13 0.03 0.0 Rural credit cooperatives 9.58 9.74 8.39 7.85 8.26 8.35 6.97 6.7 NBFIs 3.29 2.76 2.71 2.41 1.85 1.89 1.97 2.2 Postal savings banks 3.25 3.43 3.68 3.67 3.36 3.55 3.43 3.7 Foreign banks 1.50 1.84 1.91 2.11 2.38 2.16 1.71 1.8 Source: China Banking Regulatory Commission Annual Report 2009. TABLE 1C.2 Size of financial sectors or markets as a share of GDP Percent Assets of Assets of Assets of Government Financial Corporate Stock   banking insurance securities bonds bonds bonds market institutions companies companies outstanding outstanding outstanding capitalization 1999 137.0 2.9 — 11.8 7.2 0.9 29.5 2000 138.5 3.4 — 13.1 7.4 0.9 48.5 2001 145.4 4.2 — 14.2 7.8 0.9 39.7 2002 169.8 5.3 — 14.8 8.2 0.5 31.9 2003 179.7 6.7 3.6 18.0 8.7 0.7 31.3 2004 175.0 7.5 2.1 22.4 9.1 0.8 23.2 2005 175.2 8.3 — 27.3 10.8 1.7 17.5 2006 204.0 9.1 — 28.9 12.1 2.6 41.3 2007 179.6 10.9 6.5 32.4 12.7 3.0 123.1 2008 204.3 10.6 3.8 31.3 13.4 4.1 38.6 2009 237.8 11.9 6.0 29.3 15.1 7.1 71.6 2010 241.6 12.7 4.9 28.1 15.0 8.6 66.7 Sources: China Bank Regulatory Commission, China Insurance Regulatory Commission, China Securities Regulatory Commission, Securities Association of China, Bank for International Settlements. Note: Government bonds outstanding include both Ministry of Finance securities and Central Bank bills or notes. China’s Big Four remain among the 10 larg- growing somewhat in recent years though est banks in the world. they still represent only 9 percent of the There is also imbalance in the capital total. In some recent years, the share of funds markets: stocks dominate while the corpo- raised through bank loans has been as low as rate bond market remains underdeveloped. 50–60 percent, but those declines are mostly Stock market capitalization represents 67 attributable to increasing shares of fundrais- percent of GDP, roughly seven times the ing through government bonds and financial size of corporate bonds outstanding (table bonds (a large proportion of which are policy 1C.2). Viewed through the lens of the share bank bonds), rather than increases in equities of funds raised, corporate bonds have been or corporate bonds (figure 1C.2). c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 145 FIGURE 1C.2 Funds raised in the financial system (1993–2009) –20 1993 1995 1997 1999 2001 2003 2005 2007 2009 Equities Corporate bonds Financial bonds Treasury bonds Bank loans Source: China Securities and Futures Statistical Yearbook. Annex 1D Experiences of Japan and the Republic of Korea in Financial Liberalization In both Japan and the Republic of Korea, financed by issuing larger volumes of govern - financial liberalization was initiated by inter - ment bonds. This led to the initiation of inter- nal and external pressures. But the authori- est rate liberalization on government bonds ties were reactive, rather than proactive, to and certificates of deposit as holders of those developments. Institutional and governance instruments required market-based interest, reforms in banks, firms, and regulatory bod - which also had to be applied to other interest ies were very slow or even absent, leaving rates to reduce the regulatory arbitrage. fertile soil for moral hazard while interest Second, the internationalization of Japa- rate deregulation and capital market opening nese firms’ operations required the domestic was in progress. In the process, regulatory financial system to support the expansion of arbitrage and risk were increasing. This ulti- their international business, by among other mately led to financial crisis, which had to be things hedging risk exposure and meeting dealt with at huge public cost. financing requirements in foreign currencies. In Japan, three main internal and external This spurred the relaxation of the foreign forces led to financial liberalization. First, as exchange system and increased entry by Japa- the period of high economic growth reached nese financial institutions into international an end in 1974, the corporate sector’s invest- financial centers by establishing branches ment demand slowed, and firms started to and subsidiaries. Once Japanese firms were accumulate surplus funds. The household able to issue debt abroad, and Japanese finan - sector had also accumulated substantial cial institutions could make investments in financial assets (deposits) by this time and foreign assets more freely, Japanese house- started to seek assets with higher returns holds’ savings started to find their way to than bank deposits. At the same time, gov- the purchase of (Euroyen) bonds issued (at ernment budget deficits, which had expanded uncontrolled interest rates) by Japanese com- as economic growth slowed, had to be panies through Japanese banks and insurance Percent 146 china 2 0 3 0 companies located abroad. This process built However, true progress in banking sector up further pressure to liberalize the domes- liberalization was limited because the govern- tic financial system to reduce the potential ment still wanted to use the banking sector as for regulatory arbitrage and stem the flow of a tool for industrial policies and also because domestic finance to the offshore market. highly leveraged large corporations needed Third, as the Japanese economy and finan - cheap and stable finance from the banking cial market expanded, there was growing system for their survival. By this time, the interest by foreign banks and other foreign large corporate firms ( chaebols) had emerged financial institutions to penetrate the Japa - as a group with strong vested interests and nese financial market; these firms lobbied substantial influence over government eco - their governments to put pressure on Japa- nomic policies. The government instead nese officials. The continuation of Japan’s introduced greater market forces in the finan - large current account surplus dating from cial system by allowing the expansion of the mid-1970s also increased foreign pres- nonbank financial institutions (NBFIs), by sure, especially from the United States, for relaxing entry of privately owned (including the opening of the Japanese service sectors foreign) institutions such as finance compa - and capital markets, a pressure that was nies, merchant banking firms, and insurance eventually accommodated. That put further companies, which were free from policy loan pressure on the government to liberalize the programs but could offer savings accounts domestic financial system; without liberaliza - similar to bank deposits. As in the Japanese tion, the distortions and weaknesses in the case, this liberalization was also caused by domestic system would have intensified. increasing external pressure, especially from In Korea, the government’s control over the United States, as Korean financial mar - the financial system was more direct and per - kets grew larger and as a substantial current vasive than in Japan. As in China, all banks account surplus emerged in the second half were owned by the state, and their lending of the 1980s. These developments reduced activities were strongly controlled by the banks’ shares of total deposits and squeezed government through explicit policy lending their profits by shifting deposits to NBFIs. programs and implicit window guidance. This in turn pressured the government to Interest rates were controlled and set substan- allow banks to expand into products offered tially below the supposed market clearing by NBFIs such as trust accounts. rate. Government intervention grew stronger The government started interest rate lib- in the 1970s when the Korean government eralization in the late 1980s but made little initiated a strong drive to develop its heavy progress until the early 1990s when it lib- and chemical industries (HCI). This led to eralized interest rates on short-term money substantial overcapacity in the HCI sector market instruments such as commercial and a large amount of nonperforming loans paper and certificates of deposit (CDs), in the banking sector, while light industries while maintaining control on bank inter- and small and medium firms were starved for est rates. This accelerated the shift of funds credit. This in turn caused the deterioration to finance companies, other NBFIs, and of Korea’s export competitiveness, slowed the trust accounts of banks. The net effect economic growth by the end of 1970s, and was a reduction of average maturities in the culminated in the assassination of President liability side of corporate sector balance Park. Partly as a response to this negative sheets, which increasingly had to rely on experience with heavy financial repression, these short-term financing instruments. For - and as part of its overall economic liberaliza- eign exchange controls were relaxed under tion efforts, the Korean government began pressures from both domestic firms, whose gradual liberalization of the banking system business had become more globalized, and by privatizing banks and relaxing entry bar- foreign governments, which were pressured riers for other kinds of financial institutions. by their financial institutions to penetrate c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 147 uncompetitive but expanding Korean finan - of financial institutions and poorly man- cial markets. On the other hand, large chae- aged financial regulation, started to deflate bols and banks had built the perception that in 1991. Japan completed its financial liber - the government would not be able to let alization and a restructuring of regulatory them fail for fear of the impact on overall framework and government organization by economic performance. In fact, the Korean 1998, and financial restructuring by 2004. government had protected the chaebols and In the course, it experienced a prolonged and financial institutions (including small ones) deep financial crisis, which it has dealt with from failures, and no significant chaebol through injection of public funds at a huge or financial institution had gone bankrupt public cost. before 1997. The combination of these pres- sures led to two significant developments: Notes increased reliance on short-term corporate finance; and increased foreign debt, espe- 1. For a more extensive discussion of these cially short-term debt by financial institu- imbalances, see the overview of this series. 2. Indeed, industrial employment grew by just tions. In the first half of the 1990s, increased 2.3 percent a year during 1993–2007, com- foreign capital inflows and domestic sav- pared with annual value-added growth of ings were channeled to large firms, which 11.7 percent. expanded their investment recklessly, due 3. Investment rates would be supported by fur- in part to pervasive moral hazard that came ther reforms that work to sustain high rates with the perception of “too big to fail.” The of return to capital, by the large remaining first factor caused a domestic financial crisis scope for capital deepening, and by the new when overly leveraged large corporate firms investment demand generated by emerging could not service their debt and were faced social and environmental challenges (Stern with an economic recession starting 1996. 2011). Together with the first, the second factor 4. http://english.peopledaily.com.cn/200412 /06/eng20041206_166239.html. caused a currency crisis when foreign capital 5. Under the 12th 5YP, these gained added rele- flowed out massively from Asian countries in vance through changes wrought by the global 1997, which intensified the domestic finan - financial crisis. With subdued medium-term cial and economic crisis. prospects for the global economy—and thus Korea completed full liberalization and for exports—China will need to generate opening of the financial system under its more growth from domestic demand if it is post-crisis International Monetary Fund pro- to sustain relatively high rates of overall GDP gram, and undertook massive financial and growth. corporate restructuring, with huge injections 6. For example, see Kuijs and Wang (2006), of public funds (equivalent to one-third of Blanchard and Giavazzi (2006), Lardy GDP) to clean up the balance sheets of finan - (2007), and Aziz and Dunaway (2007). 7. The DRC–CGE model (2012 edition) includes cial institutions. In sum, government control 34 production sectors; 2 representative over finance was an effective vehicle for rapid households distinguished by area; and 4 pri- industrialization and economic growth in the mary production factors: capital, agricultural early stage of Korea’s economic advancement, labor, productive workers, and professionals. but it led to pervasive moral hazard in both The 34 production sectors include 1 agricul- the banking and corporate sectors, which led tural sector, 24 industrial sectors, and 9 ser- to reckless investment by favored firms and vices sectors. For a detailed description of the poor risk management of banks. In the end, model, see Li and others (2010) and He and huge amounts of public funds were required Kuijs (2007). This study has updated the pre- to remedy the problems. Similarly, Japan vious simulations by incorporating new eco- experienced a domestic financial crisis as the nomic data and adjusting some parameters in light of new empirical research. The main asset bubble, which was built during the sec- drivers of growth are technological progress, ond half of the 1980s with the moral hazard 148 china 2 0 3 0 demographics, and capital accumulation. In increasingly being aligned with that of the this model, technological progress is exoge- core budget. nous and calibrated according to China’s his- 13. This rose to more than 35 percent of GDP in torical data and international experience. In addition, the growth rate of population and 14. According to the Ministry of Finance (2011), labor is exogenous. The growth rate of capi- the gross revenue from the sale of state- tal is determined endogenously by the s avings- owned land use rights rose to 2.9 trillion investment relationship. In this model, the yuan in 2010, equivalent to 7.3 percent of basic factors driving structural change are GDP. Because a substantial share of such rev- the income demand elasticity of residents enues is paid out in the form of compensation for different commodities (the Engel effect), to displaced residents, the net proceeds from the structural change of intermediate input such sales are lower but still significant. demand resulting from technological change, 15. In 2004, the Ministry of Finance released a and factor composition change resulting from list of government funds, stipulating that no different factor accumulation speeds. government agency was allowed to charge 8. These scenarios are not meant to be precise, fees beyond this list. In 2010, the State detailed investigations of the future. Rather, Council began compiling a national bud- they are somewhat stylistic, based on analy- get for social security funds on a trial basis. sis of how key macroeconomic variables This budget initially included funds for five have related to each other in the past and types of social security: basic old-age insur- assumptions on how these relationships may ance, unemployment insurance for enterprise evolve in the coming 20 years. Many of those employees, basic medical insurance, workers’ assumptions unavoidably have an arbitrary compensation, and maternity insurance for element. urban workers. The eventual aim would be 9. Although this decline may seem fast, it is not to bring other social security funds within out of line with experiences in other South- the control of the national budget. From east Asian countries. Korea witnessed a faster 2011, the Provisional Rule on Government decline, from 50 percent in 1973 to 10 per- Funds Management includes a stipulation cent in 2001. Malaysia decreased its agricul- that all government funds revenues should tural employment share from 37 percent in be included in the fiscal budget and sub- 1980 to 18.4 percent in 2001. ject to the scrutiny of the National Peoples’ 10. Such limits could include declining margins Congress. in the production of tradable goods, excess 16. World Bank (2010a) provides a detailed dis- capacity, asset bubbles, insufficient employ - cussion on SOE dividend policy and interna- ment generation, environmental degradation, tional practices. and trade protectionism. 17. Several such taxes address negative exter- 11. Chapter 2 looks at the other policies needed nalities. Unlike many other taxes, such taxes to advance the pace of innovation, a critical present few if any trade-offs when viewed in ingredient for rapid growth by improving a more holistic way than through GDP alone, China’s technological capability and moving because they make prices better reflect the up the value chain. true marginal cost of a particular activity, 12. This compares to headline budgetary gov- including the damage to the environment. ernment size of 19.9 percent of GDP in 2008 18. Data are from Fiscal Reform and Economic (22.5 percent in 2010). The IMF’s Govern- Governance (2011), which takes into account ment Finance Statistics, a broader measure, only personal income taxes and contributions includes government activities funded by to pension funds. Including contributions to some government funds and the social pro- health insurance and housing fund, China’s tection fund. As in other countries, these overall labor tax wedge is even higher. funds are separate from the core central 19. Furthermore, the “revenue productivity” of budget. Nonetheless, they are subject to personal income tax—measured as the rev- budget-type planning and management and are sometimes presented as part of a broader enue collected as a share of GDP divided by definition of consolidated spending. The the weighted average personal income tax budget preparation cycle for such funds is rate—is only 15 percent of global averages c hina : Struc tur al r eform S for a m odern , h armoniou S , c rea tive Socie t y 149 and 11 percent of high-income-country and comprehensive or single-sector policy averages. documents. 20. This includes central government debt of 29. The latter policy is implemented by bodies RMB 6.75 trillion and subnational govern- such as the General Administration of Qual- ment debt of RMB 10.7 trillion. Of total ity Supervision, Inspection, and Quarantine; subnational government debt, 62.6 percent is the State Food and Drug Administration; explicit debt, 21.8 percent is contingent debt and the State Administration of Work Safety. (guarantees), and the subnational govern- Such inspections and reorganizations can ments have only limited rescue responsibility bring significant restructuring within sectors. for the remaining 15.6 percent. For example, in April 2011, many of China’s 21. The big three metropolises directly admin- dairies were shut down after having their istered by the central government (Beijing, licenses revoked. Shanghai, and Tianjin) have very small 30. See, for example, State Information Center county-level governments. (2007), Ou and Liu (2007) on the NDRC, 22. Jia Qinglin, “Remarks in the 3rd Conference and Yuan (2010). of Commending the Outstanding Builders 31. See, for example, Shi and Wang (2011), Jiang of Chinese Characteristic Socialism in the (2010), and Yang (2004). Private Sector,” People’s Daily, November 7, 32. At that time, the central government issued a policy aimed at eliminating outdated plants 23. “Bamboo Capitalism.” The Economist, and reducing some capacity in that indus- March 11, 2011. try. Measures included mandatory closure of 24. For example, Ferri and Liu (2009) find that outdated plants, subsidies for restructuring the cost of debt is significantly lower for and equipment replacement, and preferential SOEs, even after controlling for individual placement for fired workers. firm features. They estimate that had SOEs 33. Similar cases can be found at the provincial paid the same loan rates as otherwise equiva- and local level. For example, some local gov- lent private firms, the additional interest pay - ernments regarded the software industry as a ment would have wiped out their profit in local pillar industry and implemented prefer- 2004 and 2005, the two last years in their ential policies more than 10 years ago. How- sample. ever, the software industry remains weak in 25. However, in some sectors such as telecoms, many of these localities. the splitting up was along geographic lines, 34. Some automotive firms favored by indus- still leaving a single dominant provider in any trial policy, such as Tianjin Xiali, Guang- given area. zhou Peugeot, and Beijing Jeep have in fact 26. For example, in 2006, all of petroleum, declined, while nationally less favored firms natural gas, and ethylene production, SOEs such as Geely, BYD, and Chery have grown. controlled all basic telecoms services, about 35. The government can use state ownership as 55 percent of electricity generation, and 82 a policy tool to launch its industrial strategy, percent of airline and air cargo traffic (Owen especially as SOEs can become excellent plat- and Zheng 2007). forms for accumulating resources in times of 27. Even if entry is allowed, and even beyond economic prosperity. However, evidence sug- areas considered “strategic,” private firms gests that a persistently large-size state sector can face a range of other disadvantages. can be harmful to efficiency and equitable Ferri and Liu (2009) document significant competition in the long-term. advantages in borrowing terms for SOEs. 36. DRC staff calculation. In an overview of prospects for private air- 37. See Schneider (2010) for a detailed discus- lines in China, Pan (2010) documents other sion of EU “state aid” rules in the Chinese regulatory and financial advantages of SOEs, context. including in securing bailouts through capi- 38. Controls take the form of directed credit and tal injections and in access to bank financing; aggregate credit ceilings, floors for loan inter - and Tian (2007) documents entry barriers in the automobile industry. est rates, and caps on deposit interest rates; 28. Examples include sections of work reports to business decisions of financial institutions are CPC congresses, policy guidance for 5YPs, also controlled. 150 china 2 0 3 0 39. According to media reports, the potential projects, especially those of a commercial losses of banks lending to local government nature. Under such processes, a farmer land- platforms may be on the order of 2 trillion owner may demand 40 –50 percent of the yuan. expropriated land as compensation in lieu of 40. Finding domestic strategic investors would cash and thus share partially but significantly be difficult. Selling banks to foreign strategic in the gains from such development. investors may not be politically acceptable, 47. For more discussion of factors behind past and it might be difficult to find willing and performance, see Hofman and Wu (2009), able buyers for a variety of reasons. Privati- Huang (2011), and Vincelette and others zation by placement of government shares (2011). with small individual investors would not 48. Kuijs (2010) finds TFP growth of 3–3.5 per - be a good option either, because the govern- cent a year from 1978 to 2009, of which ment would continue to be able to control the about 0.5 percent comes from enhanced bank’s management and operation. human capital. Bulman and Kraay (2011) 41. Financial institutions continue to be subject find TFP growth of 3.0– 4.1 percent a year to a floor on lending rates and a ceiling on from 1979 to 2008, over one-half of which deposit rates. The cap on deposit rates has they attribute to factor reallocation. been circumvented to a certain extent by the 49. 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By raising the ratio of capital to labor and Both technology catch-up through tech- rapidly assimilating technologies across a nological absorption and innovation at the wide range of activities, China has increased technological frontiers will rest on several factor productivity manifold since 1980 factors, including the success of policies and entered the ranks of middle-income focused on effective competition; the compo- countries. With the launch of the 12th Five sition of the business sector and its strategic Year Plan, China has reaffirmed its goal of orientation; agile policy making and robust becoming a moderately prosperous society regulation that minimize the risk of crises by 2020. This chapter maintains that China (from asset bubbles, for example, that can can become a high-income country by 2030 depress innovative activity) and that position through a strategy combining high levels the economy to seize evolving opportunities; of investment with rapid advances in tech- skill development; research and development nology, comparable to the strategy used by (R&D); national and international network- Japan from the 1960s through the 1970s and ing to promote innovation; and the nurturing by the Republic of Korea from the 1980s of innovation especially in the areas of green through the end of the century. During the technologies, health and medical services, next decade, more of the gains in produc- and urbanization modes, and in major urban tivity are likely to derive from technology centers. absorption and adaptation supplemented by A competitive market environment is incremental innovation, while high levels of the precondition for a steady improvement investment will remain an important source in productivity. Starting in the late 1980s, of growth in China through capital deep- for example, market-enhancing reforms ening and embodied technological change. increased entry of foreign and private firms By 2030, China expects to have pulled and stimulated competition in most of Chi- abreast technologically of the most advanced na’s manufacturing subsectors. Even in some countries and increasingly, its growth will “strategic” or “pillar” industries (for exam- be paced by innovation that pushes the ple, airlines and telecommunications), the 155 156 china 2 0 3 0 breaking up and corporatization or exit of in pedagogical techniques, with greater use incumbent, mainly state-owned enterprises of multimedia and flexible online training (SOEs) in the 1990s strengthened competitive customized to the varying needs of students. pressures. More recently, the phasing out of That, in turn, will raise the productivity of tax incentives that had favored foreign inves- the education sector overall and maximize tors stimulated competition by leveling the the benet fi s from the limited pool of talented playing field with domestically owned firms. instructors and the available physical facili- China’s accession to the World Trade Orga- ties. The effectiveness of traditional standard- nization (WTO) in 2001 increased competi- ized approaches to training such as lectures tion from imports, and the large volume of to large classes may need to be reconsidered, foreign direct investment (FDI) has led to a with institutions being encouraged to experi- further intensification of competitive pres- ment with supplementary modes of partici- sures. Sustaining this trend through insti- patory learning and given the autonomy to tutional reforms and measures to enhance do so. the supply of risk capital will be critical to China’s spending on R&D is on a steep the making of an innovative economy, because upward trend. This spending will increase it will stimulate the deepening of the private the production of ideas and prepare the sector, reduce barriers to firm entry and exit, ground for innovation. But because most promote the growth of dynamic small and applied research and innovation are done medium enterprises (SMEs), prod the SOEs to within firms and because the majority of raise their game (and pave the way for further scientists will be employed by businesses, reform), and result in national market integra- the commercialization of ideas will flourish tion as well as much needed regional or local and drive productivity only when firms make specialization of industry. innovation a central plank of their business The speed with which advanced technolo- strategies. How quickly firms take advantage gies diffuse and the capacity to innovate will of the knowledge capital being created by be keyed to the availability of a vast range R&D will be a function of market growth of technical and soft skills such as manage- and competition, the quality of the work- ment, research, design and production, the force, and fiscal and other incentives that effective harnessing of information technol- prioritize research-intensive activities. Agri- ogy (IT) and of marketing and customer cultural research will also continue to con- relationships. By 2030, China is expected tribute substantially to productivity gains, to have up to 200 million college graduates, price stability, and food security. more than the entire workforce of the United An adequate volume of much-needed basic States. Moreover, university-level education research, by virtue of its public good charac- is improving—China now has 11 universi- teristics, will depend upon government initia- ties in the top-ranked 200 universities of the tives and funding. Government agencies, key world. Even so, the quality of tertiary edu- universities and research institutions, and cation more broadly is a matter of concern, some large corporations will need to take and some employers are experiencing a seri- the lead, especially in high-risk, blue-skies ous shortage of the skills required to upgrade research, through well-targeted incentives, processes and the product mix. For China to by committing a sufficient (and sustained) become an innovative knowledge economy, volume of funding to high-caliber institu- increased investment in human capital will tions, and by means of prizes and awards. In be critical to build analytical and complex the United States, the National Institutes of reasoning capabilities, enhance scientific Health have played a central role in boosting literacy and the knowledge base of students, innovations in life sciences, as have agencies encourage creativity, and instill communica- such as the Departments of Defense, Energy, tion and teamwork skills. Raising the quan- and Agriculture and the Defense Advanced tity and quality of skills demands innovation Research Projects Agency (DARPA). c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 157 Increased publishing of scientific papers significant long-run spillover effects, the and patenting is likely to have only a small reputational gains for Chinese cities (a few of impact on productivity growth—even if which are fast becoming science hubs), and China is able to raise R&D spending to 2.2 the contribution such research can make to percent of GDP by 2020—unless the qual- industrial upgrading. Closer collaboration ity of this research and its commercial rel- and partnerships with multinational corpo- evance and uptake is substantially increased. rations on the basis of mutual trust and rec- Good research must be complemented by a ognition will contribute to the making of a stringent and disciplined process of evalu- dynamic and open innovation system. In this ation and refereeing of research programs context, an efficient and discriminating pat - and findings, with the feedback incorporated enting system that learns from the experience in policies. The research community needs of the U.S. and European systems (both of to take the initiative here to uphold ethics which are in the throes of reform) and effec- and set high standards, with public agencies tive protection of intellectual property, espe- providing the ground rules. Universities can cially in technologically dynamic fields such reach out more actively than public research as biotechnology, nanotechnology, software, institutes to the business community to and multimedia, will expedite the growth of maximize the relevance of the research con- China’s innovation capabilities. ducted and to serve the cause of learning by Smart cities will be the locus of technolog- promoting public lectures and exhibitions, ical innovation and of nascent green growth and contributing to the teaching of science in in China as in other advanced countries— local schools. Beyond that, it is up to firms and urban development strategy intersects to transform research findings into prot fi able with strategies for technology development products and services. and growth. Innovative cities take the lead in The central government can help build building large pools of human capital (espe- countrywide research networks to mobi- cially in attracting many science and technol- lize national talent and create consortia ogy workers) and in embedding institutions composed of firms from inland and coastal that support the generating, debating, test- areas to raise the technological levels of all ing, and perfecting of new ideas. Innova- participants through cross-fertilization. Gov- tive cities serve as the axes of regional and ernments in Japan, the United States, and even international knowledge networks; Taiwan, China, have successfully sponsored they derive technological leverage from an similar consortia, and they can help China industrial base that employs scientific and develop more firms that are “global chal- technological talent; they are home to a few lengers.” The domestic research networks leading, research-oriented firms and provide should be incorporated into global research a business environment conducive to the networks so that Chinese companies can multiplication of SMEs; and they invest in also participate in research conducted in state-of-the-art digital networks and online other parts of the world. Such participation, services. Such cities thrive on the heteroge- and with it the creation of global research neity of knowledge workers drawn from all networks, will be promoted by measures over the country—and the world. Moreover, that improve internal organizational and such cities are closely integrated with other technological capacities and by policies that global centers of research and technology minimize protectionist tendencies in other development. Finally, innovative cities are countries. “sticky” because their knowledge environ- Many high-tech multinational corpo- ment, physical and cultural amenities, public rations have invested in R&D facilities in services, and quality of governance attract China (including in inland cities such as and retain global talent. Xian and Chengdu). Such investment should International experience suggests that be encouraged because of its potentially stickiness derives in large part from the 158 china 2 0 3 0 presence of world-class research universi- Purpose of the Chapter ties that China is committed to creating. China is determined to become a global inno- China will need to endow its premier insti- vative powerhouse by 2020. Policy analy- tutions with a measure of autonomy from sis has shown that productivity gains from government not only to succeed in stimu- structural changes and technological catch- lating urban innovation but also to ensure up will be largely exhausted within a decade that they are disciplined by competition and and that thereafter, growth rates in the 6–7 indicators of performance and remain effi - percent range will be increasingly tied to cient providers of services. These universi- productivity gains stemming from innova- ties must interact with employers to impart tiveness in its several forms. The purpose of technical and soft skills as well as the latest this chapter is twofold: The first is to exam - industry know-how. China’s front-ranked ine the scope for productivity gains even as schools must mobilize the funding and staff the technological gap between China and faculty positions needed to sustain cross- the advanced countries narrows and to sug- disciplinary postgraduate and postdoctoral gest how China could hasten the pace of programs, introduce innovative approaches technological catch-up by creating a more to imparting knowledge and analytical competitive economic environment and a skills, and establish specialized, well-staffed world-class innovation system. The second is research institutes, some of international to sketch a menu of policies that could help to standing. An important contribution uni- make innovation a major driver of growth in versities can make to innovation is to groom the new phase of development. The two are the entrepreneurs of tomorrow who can closely interrelated. Policies that promote transform ideas into commercial products technological catch-up over the medium run and services. overlap with those that can enlarge innova- With a yearly influx of more than 10 tion capacity over the longer term. million people to its cities, China needs to The chapter is divided into four parts. The optimize the planning of urban develop- first underlines the increasing significance ment, build energy-efficient mass public of total factor productivity growth (TFP) as transportation systems, provide affordable a source of growth, describes China’s per- housing, and inculcate sustainable urban life formance since 1980, and examines sectoral styles. Smart and green urbanization will trends. The second reviews China’s prog- stimulate both research on and the com- ress in building technological capacity. The mercialization of green technologies. Energy third assesses China’s strengths and some of pricing reform and enforcement of national the constraints hindering the development environmental and energy efficiency stan - of innovation capabilities. And the fourth dards will create pressures to upgrade tech- is devoted to the discussion of national and nologies, and urban development will be subnational policies that would enable China the main venue for introducing new con- to realize its ambition of eventually becoming struction materials and technologies for an innovative nation on par with the United transport, heating, cooling, and many oth- States, Japan, Germany, and Korea, albeit ers urban needs. Demand-side instruments one capable of sustaining a higher rate of such as government procurement and stan- growth than these mature economies. dard setting can also spur innovation. The key to success, however, will lie in genuine open competition supported by sound and Growth Drivers: Betting on TFP responsive policy making. Among the larger East Asian economies, only China may need to develop a culture that three were able to transition from the middle- encourages more people to boldly pursue income to the high-income category during new ideas and to push the frontiers of knowl- the second half of the 20th century. Japan edge across a variety of fields. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 159 did so in the 1960s, and Korea and Taiwan, all three economies because their industries China, during the 1990s. Japan made the are at the cutting edge and growth must lean transition by means of a high-investment, more heavily on productivity gains deriving manufacturing-sector-led growth strategy in part from successful innovation. that combined technological catch-up with This experience has a number of implica- both incremental and disruptive innovations tions for China’s growth strategy. First is the introduced by the private sector but enabled need to fully exploit the potential of techno- by the government’s industrial and technol- logical catch-up in industry and services for ogy policies. The pocket transistor radio, the at least the next decade. During this period, Walkman, compact automobiles, and lean original innovation based on technologi- manufacturing were some of the disruptive cal breakthroughs may not be as common innovations introduced by Japanese firms that as innovations combining different existing contributed to productivity gains and export technologies or the introduction of innovative successes. Korea and Taiwan, China, also designs and special features customized for relied on technological catch-up facilitated by specific markets. Second, innovation capa- high levels of investment in manufacturing, bility takes years to accumulate, and system- and both benefited from incremental inno - atically defining and implementing an inno - vation as their industries matured. Research vation strategy would begin yielding sizable and development facilitated technology dividends in the form of frontier expertise absorption although the contribution to pro- and groundbreaking discoveries most likely ductivity growth via breakthrough innova- in the 2020s and beyond, when China would tion was quite limited through the late 1990s be more in need for a productivity boost except in Japan, whose technological capabil- from this source. Third, the quality and ities in the 1950s and earlier put it in a differ- efficiency of the innovation system deserves ent league from the other two. Governments priority over indicators such as R&D spend- actively engaged in deepening human capi- ing, patents, and published papers—after tal, improving access to financing, and all, innovation should create wealth. And, encouraging the borrowing and assimilation fourth, realizing productivity gains will be in of technology and investment in productive the hands of the business sector, and it is the assets. But it was leading manufacturers, dynamism of firms that will be the ultimate assisted by clusters of smaller suppliers, that arbiter of growth-enhancing innovativeness. spearheaded technology absorption and inno- vation. Korea and Taiwan, China, gradu- Accounting for China’s Growth ated from the middle- to the high-income group of economies largely on the basis of A decomposition of China’s growth rate is an technological catch-up and the building of appropriate starting point. A meta-analysis globally competitive electronics, transport, of 150 studies of total factor productivity and chemical industries with strong export growth in China (Tian and Yu 2012) con- performance. The two economies began cludes that since 1978, the annual contribu- strengthening their innovation systems in the tion of TFP on average has been 2 percent- 1980s through public and private investment age points, with the eastern region registering in research infrastructure, systematic bor- higher rates than the central and western rowing from overseas through licensing and regions (see below). Other research provides FDI (in the case of Taiwan, China), among detail on subperiods and sectors. For exam- other channels. The acceleration of techno- ple, a study conducted by Bosworth and logical progress during the 1990s and early Collins (2007) shows that physical capital 2000s enabled them to cross the threshold and TFP contributed 3.2 percentage points and join the club of high-income economies. and 3.8 percentage points, respectively, to The importance of innovation has contin- China’s GDP growth between 1978 and ued to increase and is now paramount for 2004. From 1993 to 2004, their shares 160 china 2 0 3 0 TABle 2.1 Sources of growth, 1978–2004 Annual percentage rate of change Contribution of: Period Output Employment Output per worker Physical capital Land Education Factor productivity Total 1978–2004 9.3 2.0 7.3 3.2 0.0 0.2 3.8 1993–2004 9.7 1.2 8.5 4.2 0.0 0.2 4.0 Source: Bosworth and Collins 2007. TABle 2.2 Sources of growth by industrial and services sectors, 1978–2004 Annual percentage rate of change Contribution of: Period Output Employment Output per worker Physical capital Education Factor productivity Industry 1978–2004 10.0 3.1 7.0 2.2 0.2 4.4 1993–2004 11.0 1.2 9.8 3.2 0.2 6.2 Services 1978–2004 10.7 5.8 4.9 2.7 0.2 1.9 1993–2004 9.8 4.7 5.1 3.9 0.2 0.9 Source: Bosworth and Collins 2007. were 4.2 percentage points and 4.0 percent- machinery and motor vehicles during 1999– age points, respectively (table 2.1) with 2004 (ranging from 2.71 to 2.83 percent a industry overshadowing other sectors. Capi- year). Glass and clay products and paper also tal and TFP contributed 2.2 and 4.4 percent- registered large gains (see annex table 2A.1). age points, respectively, of industrial growth According to more recent estimates by during 1978–2004 and 3.2 and 6.2 percent- Kuijs (2010), TFP growth slowed to 2.7 per- age points from 1993 to 2004 (table 2.2). cent between 1995 and 2009, and the share Agricultural output grew steadily at an aver- of capital rose to 5.5 percent. Growth of age annual rate of 4.5 percent between 1978 productivity in services also slowed from 1.9 and 2009, with TFP gains averaging 2 per- percent (1978–2004) to just 0.9 percent a cent a year. The performance of agriculture year between 1993 and 2004 (Bosworth and was aided by market incentives, ownership Collins 2007). reform, land-saving technologies, and the With capital spending subject to decreas- diversification of production from grains to ing returns (as is evident from the upward higher-value items such as meat and vegeta- trend in incremental capital-output ratios, bles. Chen, Jefferson, and Zhang (2011) show or ICORs), the scope for raising growth that TFP rose even more rapidly in most man- through larger injections of capital is being ufacturing activities during 1981–2008, with rapidly exhausted. Moreover, rebalancing of electrical and nonelectrical machinery, office consumption spending will lead to a decline equipment and telecommunications subsec- in the share of investment. At the same time, tors, which have benefited most from tech - the structural transformation of the Chinese nological change, in the forefront (Jorgenson, economy is entering a stage when productiv- Ho, and Stiroh 2007). However, metal and ity gains from the intersectoral transfer of nonmetal industries, plastics, rubber, petro- resources will continue to taper off (Chen, chemicals, and paper achieved comparable Jefferson, and Zhang 2011). In most high- gains. Ito and others (2008) reaffirmed these income countries, TFP growth averaged less findings. Growth of TFP was strongest for than 2.0 percent a year between 1995 and c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 161 19 24 2009, the exceptions being Korea and Ire- chain vulnerabilities and transaction costs), land, which had rates of 2.7 percent and 3.1 could increase the share of higher-tech items percent respectively—although Ireland fell to produced domestically and steadily reduce 1.3 percent and Korea to 2.6 percent during the imported content of China’s manufac- 2005–09. tured exports, which has already declined International experience offers three point- from 52.4 percent in 1997 to 50.6 percent ers: First are the advantages of a continuing in 2006 (Koopman, Wang, and Wei 2009). emphasis on those manufacturing industries This trend is likely to reverse past tendencies that are likely to deliver the highest returns for imported inputs to increase initially as from catching up so long as Chinese firms the skill intensity of production rises (Moran are quick to pursue technological possibili- 2011b). Product space analysis pioneered by ties and strive to maximize efficiency gains. Cesar Hidalgo, Ricardo Hausmann, and oth- These include industries such as electrical ers (Hausmann and Klinger 2006) suggests machinery, office and computing equipment, that the average sophistication of China’s pharmaceuticals, aircraft, motor vehicles, and exports is comparable to that of Malaysia, nonelectrical machinery, which have dem- Thailand, and the Philippines. onstrated rapid improvements in technology Since 1985, China has broadened its pro- because they are also the most R&D intensive duction base and, through massive invest- (van Pottelsberghe de la Potterie 2008). ment, has enlarged production capacity and Second, catching up and innovation in ser- accelerated learning by doing. As a conse- vices, promoted by information and commu- quence, China now produces a wide assort- nications technology (ICT), is likely to play a ment of products that can be technologically more prominent role over the longer run as upgraded and from which Chinese manufac- the share of services in GDP begins to over- turers can diversify into other related prod- shadow industry. Services growth would ucts. In product space terminology, more of involve encouraging innovation by firms the products lie in the densely networked engaged in banking, insurance, retailing, real core that multiplies options for industrial estate, logistics, and data services as well as diversification and the scope for innovation. health care and education, two important A closer inspection of the products in and growing activities. China’s export basket with the highest den- Third, lowering market barriers to the sities underscores China’s rapid industrial entry, growth, and exit of firms will contrib - progress. In 1987, the top 10 commodi- ute to economywide improvements in pro- ties were mainly low-tech items that offered ductivity growth by intensifying competition minimal opportunities for diversification. and with it the process of creative destruction By 2006, the product composition had (McKinsey and Company 2010). altered radically, with many opening avenues The trends in manufacturing are promis- for upgrading into more technologically ing. Chinese manufacturers of transport and advanced products with better market pros- telecommunications equipment, consumer pects. China’s industrial capabilities are thus electronics, and textiles and garments are strengthening, as is its competiveness relative aggressively engaging in backward and for- to higher-income countries. In recent years, ward integration, moving from the assembly the increase in product complexity and the and testing of standardized products to the share of products employing advanced tech- design and manufacture of differentiated nologies is linked to investment by multina- parts and components and of new products tionals in upscale manufacturing activities that generate higher profit margins. These (Koopman, Wang, and Wei 2008, 2009). efforts, if they are aided by a consolida- These findings are similar to those of Felipe, tion of global production networks (result- Abdon, and Kumar (2010). ing partly from the pull of agglomeration The trend in patenting during 2005–09 economies and partly from emerging supply indicates that the changing composition of 162 china 2 0 3 0 manufacturing is serving to upgrade domes- scientific services (annex table 2A.4). Urban tic technology. The largest number of patents development and the continuing structural received by residents of China who registered transformation of the economy are facilitat- with the United States Patent and Trade- ing the entry of small firms, which in turn mark Office (USPTO) was for electronic contributes to patenting and the introduction and electrical devices, followed by commu- of new products. Small firms are, on average, nications devices, software, pharmaceutical more efficient in using R&D resources— compounds, and optical devices (annex table financial and human—to generate patents 2A.2). Similarly, the overwhelming majority (annex tables 2A.5, 2A.6, and 2A.7). Look- of patents granted to residents of China by ing ahead, there is more room for growth of the World Intellectual Property Organiza- services activities and for competition that tion (WIPO) was also for electronic, electri- would raise efficiency. cal, and telecommunication devices followed The data on new domestic firms entering 27 28 by chemical and biological products and manufacturing subsectors is consistent with products in the mechanical engineering cat- FDI data, which show that the two subsec- egory (annex table 2A.3). tors most favored by foreign investors are Among manufactured products, elec- computers and other electronic equipment, tronic, telecommunication, and optical followed by chemicals, universal machinery, devices are likely to remain the technologi- and special purpose machinery. The share of cally most dynamic products, the focus of computers and electronic equipment, while innovation, and a continuing source of still high, has declined since 2004; the shares increases in productivity in the world and in of the others have remained largely stable China. Chinese companies such as Huawei (annex table 2A.8). and ZTE are emerging as world leaders in International experience suggests that the the telecommunications sector and role mod- contribution of small and medium compa- els for others seeking to establish a signifi - nies to innovation is likely to increase. This cant presence in the global market. desirable development can be facilitated by measures to reduce entry barriers, including transaction costs for SMEs, and to make it entry of Firms by Subsector easier for them to access financing. China’s emerging comparative advantage in manufacturing subsectors is supported by Building Technological Capacity data on the entry of new firms. The subsec - tors with high rates of new entry are metal Before the Industrial Revolution in Europe, manufacturing, machinery, and electrical, China led the world in technology. After computing, and telecommunications equip- losing ground for more than 250 years, China ment. Meanwhile, business, scientific, and now is sparing no effort to become a global technical services are growing robustly as force in technology, and possibly even again China urbanizes and consumption shifts the leader, by 2030. China began piecing toward services. The statistics on firm entry together a strategy starting in the 1980s with for Guangdong reaffirm the importance of an emphasis on manufacturing capabilities garments and leather products as well as the and cost innovation in major product catego- strength of industries producing metal prod- ries. The next step was to increase the acqui- ucts, machinery, and computing equipment. sition of foreign intellectual property (IP) Business services are also a growth sector in complemented by reverse engineering. Since Guangdong. Machinery and transport equip- the late 1990s, China has attempted to maxi- ment and plastics are the favored subsec- mize technology transfer through foreign tors in Zhejiang. And in both Zhejiang and direct investment, in particular by encour- Beijing, as well as in coastal provinces, the aging multinational corporations to conduct conspicuous growth drivers are business and more of their R&D in China. The transfers c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 163 and spillovers that resulted have fallen short important, the national program also has 16 of expectations. Research analyzing Chinese specific subprograms—from core electronic and international experience suggests—albeit components to moon exploration—aimed with qualic fi ations and exceptions—that mul - at achieving advances in core common-use tinationals thus far have generated few techno- technologies and enhancing the capabilities logical spillovers and those that have occurred of Chinese enterprises. During the 11th 5YP are in high-tech sectors and have remained in period and through 2011, the central gov- the vertical plane, that is, from end users to ernment’s outlay on science and technology suppliers, rather than also spreading horizon- rose by 22 percent a year. By 2011, R&D tally to other sectors (Moran 2011a, 2011b). accounted for 1.83 percent of GDP. In low-tech sectors, the spillover effects might Innovation and technology development are even be negative. Moreover, where multina- assigned a central role in the 12th 5YP (2011– tionals fear that their intellectual property 15), with the highest priority given to: might be compromised, they are reluctant to introduce the latest technologies or to conduct • Developing strategic industries such as frontier research aside from taking precau- energy-saving and environmental pro- tions to minimize technology leakage (Moran tection, next-generation information 2011a, 2011b; Fu and Gong 2011; Tang and technology, biotechnology, high-end man- Hussler 2011; Bai, Lu, and Tao 2010; Fu, ufacturing, new energy, new materials, and Pietrobelli, and Soete 2011). In the light of clean energy vehicles. A number of mega- this experience, China is redoubling its own projects with a focus on basic research efforts at technological upgrading, indigenous are earmarked for a large injection of innovation, and takeover of foreign firms resources starting in 2011. Two that have and their brands by China’s leading challeng- been singled out are in the life sciences— ers, while supporting determined efforts by on drug discovery and on major infectious Chinese firms to innovate, build their own diseases—reflecting the view that research brand image, and expand their share of global on biopharmaceuticals and stem cells markets. This approach is exemplified by might lead to prot fi able innovations. Lenovo (Tzeng 2011). • Promoting enterprise-led innovation. • Strengthening supporting services. • Raising expenditure on research and Planning Technology Development development to 2.2 percent of GDP. in China • Increasing the rate of patenting to 3.3 pat- The 11th Five Year Plan stated that China ents per 10,000 people. would build competitive advantage based on science, technology, and innovation, and this An increase in R&D is being comple- objective remains prominent in the 12th plan. mented by investments in the physical infra- In early 2006, the government announced its structure supporting technological upgrad- National Program Outline for Medium and ing. Strengthening and more fully exploiting Long Term Development of Science and Tech- the potential of multimodal transport is help- nology (2006–2020). Its key pillars include ing to raise logistics efficiency. And massive “indigenous innovation,” “a leap-forward in investments in renewable sources of power, key areas,” “sustainable development,” and a smart grid, and rail transport are expected “setting the stage for the future.” The strat- to reduce energy consumption. Mobile net- egy seeks to encourage enterprise-led innova- works were serving 1.1 billion users by 2012, tion; to strengthen intellectual property pro- an increase of 650 million over 2006. In tection; to create a favorable environment for 2012, of the 564 million internet users, 530 innovation in science and technology (S&T); million had access to broadband services, to attract S&T talents; and to improve the more than the total population of the United management and coordination of S&T. More States (g fi ure 2.1). 164 china 2 0 3 0 FiGure 2.1 China’s communication infrastructure and mobile networks, 2002–12 a. China mobile subscribers and penetration rate b. The growth of broadband subscribers and Internet users 1,200 90 45 1,000 500 70 35 800 60 30 30 200 15 20 10 0 0 0 2002 2004 2006 2008 2010 2012 2002 2004 2006 2008 2010 2012 Mobile subscribers (left axis) Broadband subscribers (left axis) Internet users (left axis) Mobile penetration rate (right axis) Broadband penetration rate (right axis) Internet penetration rate (right axis) Sources: Data for mobile subscribers: Ministry of Industry and Information Technology, P.R. China (http://www.miit.gov.cn/n11293472/n11293832/n11294132 /n12858447/index.html); data for broadband subscribers: Ministry of Industry and Information Technology, P.R. China (http://www.miit.gov.cn/n11293472/n11293832 /n11294132/n12858447/index.html); data for Internet users: China Internet Network Information Center (http://www.cnnic.net.cn). Furthermore, full-time equivalent R&D for example) is yielding promising results personnel tripled, from 750,000 to 2.3 mil- (Hassan 2005; Bai 2005; Preschitschek and lion person-years, and the total number of Bresser 2010; Italian Trade Commission personnel engaged in S&T activities reached 2009; Leydesdorff 2008). 4.97 million in 2008. Some 6 percent of Chi- However, as yet, China has relatively few na’s 1,700 institutions of higher education high-impact articles in any field (Simon and are elite Project 211 entities responsible for Cao 2009; Royal Society 2011), although training four-fifths of doctoral candidates, according to the social science citation index, hosting 96 percent of key labs, and contribut- China’s citation ranking rose from 19th place ing 70 percent of the funding for university in 1992–2001 to 13th in 1996–2005 to 10th research. A total of 218 national priority labs place in 1998–2008 (Hu 2011, 102). now cover all the major scientific fields. Mirroring the trend in publications, the Between 1996 and 2000, China’s global number of patents granted to Chinese enter- science citation index ranking as measured prises dramatically increased from 5,386 by publications increased from 14th to 2nd in 1995 to 76,379 in 2006. The number place (Adams, King, and Ma 2009). The of patent applications to WIPO increased output of publications soared from 20,000 from about 23,000 in 1996 to 290,000 in in 1998 to 112,000 in 2008, equal to 8.5 2008 (Hu 2011, 103). A continuing sharp percent of global output of scientific publica - increase through 2009 propelled China to tions. A study conducted by Britain’s Royal fifth place in WIPO’s rankings, but again Society found that between 2004 and 2008, quantity has not yet been matched by the China produced more than one-tenth of the quality of the patents. Incentives to patent published scientific articles while the United (including incentives offered by provincial States, produced one-fifth, putting China authorities) have produced a flood of minor in second place (ahead of the United King- design and utility patents that contribute dom). Chinese research publications lead little to advances in knowledge or commer- the field in materials science, physics, chem - cial innovation. Most of the high- and mid- istry, and mathematics. Moreover, Chinese value patents are being registered by multi- research in nanoscience (which is likely to national corporations (Boeing and Sandner affect the development of advanced materials, 2011, table 9). Triadic patent filings (with Subscribers, millions Percent Subscribers, millions Percent c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 165 the patent offices of the United States, the foreign-owned firms or joint ventures. For - European Union, and Japan), a better mea- eign firms also account for more than 85 per - sure of the worth of a patent, are increasing cent of high-tech exports since 1996 (Moran but are still few in number. In 2009, China 2011b). Having no big marquee brands or ranked 11th in the world, having filed 667 core technologies, China reaps only a small triadic patents compared with 1,959 by portion of rents from high-tech exports, Korea, 12,715 by the United States, and which accrue mainly to foreign designers and 13,332 by Japan. In 2010, the numbers of engineers. The most illustrative example is patent applications filed by Chinese residents the case of Apple’s iPad and iPhone. All iPads to the United States Patent and Trademark and iPhones on sale worldwide are assembled Office, the European Patent Office, and the in China by the Taiwanese company Fox- Japan Patent Office, stood at 6,978, 2,049, conn with homegrown Chinese companies and 1,063, respectively, an increase over supplying not a single component. In the case 2008 of 19.6 percent, 35.7 percent, and 37.7 of iPhone, the only value captured in China percent. is the wage earned by Chinese assembly By official count, the number of sci- workers, which accounted for 1.6 percent of ence- and technology-based private firms in the sales price; Apple’s prot fi s accounting for China increased from just 7,000 in 1986 to 58.8 percent (Kraemer, Linden, and Dedrick 150,000 in 2006, and as of 2007, the assets 2011). of privately owned Chinese companies were approaching those of the SOEs, not including China Versus Other economies the 100 largest (OECD 2010). Now a small number of Chinese firms, such as Huawei How does China’s performance to date com- and ZTE in the ICT industry, Suntech Power pare with that of the leading economies? For in solar technologies, and Dalian Machine one thing, China’s growth has been higher Tool Group in engineering, have reached or over a longer period buoyed by above-average are approaching the international techno- productivity gains. But the data on industrial logical frontier and demonstrating a grow- value added and technological indicators sug- ing ability to create technology. Chinese gest that plenty of rungs are left to climb on companies are also mastering the latest tech- the technology ladder. By pouring resources nologies in areas such as auto assembly and into S&T development, China has moved components, photovoltaic cells, biopharma- faster than most of its neighbors in laying 52 53 ceuticals, nanotechnology, stem cell ther- the foundations of a world-class innovation apeutics (Gwynne 2010), high-density power system. The efficiency of the emerging inno - 54 55 batteries, high-speed trains, telecommu- vation system is questionable; however, the nication equipment, wind turbines, single- quality will need improving, and the urban aisle passenger aircraft, booster rockets, dimension has been relatively neglected (see space satellites, supercomputers, shipping next section). containers, Internet services, electric power Starting in the 1980s, China began to turbines, and many other products. Many reform its science and technology system and of the companies introducing innovative initiated four programs—Key Technologies products are state owned. R&D (1982), Spark (1986), High-Technology These achievements notwithstanding, Research and Development (“863”) (1986), the reality is that much of China’s export- and Torch (1988)—aimed at making science oriented manufacturing industry is still and technology serve economic growth and engaged in processing and assembly opera- social development, and enhancing S&T tions, export competitiveness is predomi- capacity to complement China’s investment nantly based on low factor costs, and more in manufacturing capabilities. These and than half of all exports are produced by other reforms and programs introduced 166 china 2 0 3 0 since, with the focus shifting to innova- five pillars: the institutional environment; tion after 1990, are now producing results. human capital; training and social inclusion; A number of multidimensional indexes that the regulatory and legal framework; and the measure capabilities across countries show adoption and use of ICT. Sweden received that China is rapidly augmenting S&T skills, the highest ranking in 2010–11 followed by building research infrastructure, and assimi- Switzerland and Singapore, Finland, and the lating information and communications United States. This index puts China in 64th technology. place even though the report recognizes its According to a ranking of 40 countries vast potential and huge investment in tech- produced by the Chinese Academy of Science nology. The report observes, however, that and Technology for Development, China is China’s R&D base is still somewhat weak as in 21st place in its innovative capacity, with are the regulatory and legal frameworks. a point score of 58 compared with 100 for The European Innovation Scoreboard the United States. The index was constructed compares China’s performance on several from five major subindexes based on 31 indi - benchmarks with the EU-27. The most cators. The various subcomponents indicate recent report concludes that the European that China’s performance has improved since Union (EU) countries are ahead of China on 2000 in knowledge creation (it is now in 33rd most of the indicators of education and inno- place—a five-point improvement). Innovation vation capability. However, China is increas- performance has risen sharply to ninth place. ing its lead in medium- and high-tech exports But as the report observes, efficiency, inten - and drawing abreast of the EU in tertiary sity, and quality of research in China still lags education, international publication, business behind the frontrunners—the United States, R&D, and patenting, while the EU is extend- Switzerland, Japan, and Korea—it is seeking ing its lead in public R&D expenditure and to match. most-cited publications. Another ranking of countries by innova- INSEAD’s Global Innovation Index pro- tiveness comes from the Information Tech- vides a fifth measure of China’s capabili- nology and Innovation Foundation (ITIF). ties. This index ranks 125 countries using This index covers 40 countries and is based measures of innovation input (such as insti- on measures of human capital, investment tutions, human capital, infrastructure, and in R&D, and numbers of scientific articles, market and business sophistication) and entrepreneurship, IT, economic policy, and output, both scientific and creative. China economic performance—in other words, this was ranked 29th in 2011, the three top- index casts its net broadly. Singapore leads ranked countries being Switzerland, Sweden, the ITIF list with a score of 73, followed by and Singapore. Like the European Innova- Sweden, with the United States in 6th place tion Scorecard, this index points to China’s and China ranked 33rd. The ITIF also pre- improving performance—China’s position pares a separate ranking of the change in actually declined from 37th place in 2009 to country scores to determine the scale of inno- 43rd place in 2010 before reaching its current vation effort and progress between 1999 and position. 2009. By this measure, China comes first, fol - A sixth index of “Science and Technology lowed by Singapore and a number of north- power,” computed by Angang Hu, compares ern European countries. Interestingly, the China with the four leading nations—Ger- United States ranks dead last in this listing many, Japan, the United Kingdom, and the because it is the country at the technological United States—on five capacities: publica- frontier in most areas and because of its weak tions, patents, computer usage, Internet performance on a number of counts. access, and R&D spending. Each of these is The European Business School is the given equal weight, and Hu (2011, 110) finds source of a third measure, known as the that China’s global share of S&T power rose Innovation Capacity Index, which rests on from 0.82 percent in 1990 to nearly 4 percent c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 167 in 2000 and to 9.7 percent in 2007, putting fastest-growing industries have emerged in it in third place behind the United States and a relatively small number of cities. China’s Japan. “reform and opening” since 1979 com- These six by no means exhaust the indexes menced with the establishment of four of innovation capabilities. Several others Special Economic Zones privileged with arrive at rankings for selected countries by incentives for export-oriented industrializa- fusing measures of competitiveness, scien- tion, which were subsequently extended in tific and technological knowledge, ICT, and 1984 to 14 coastal cities and to several new human capital. Information on these rank- coastal economic zones. These urban cen- ings and a synthetic index constructed by ters and regions triggered and have crucially Archibugi and Coco, are helpfully summa- sustained China’s remarkable economic per- rized by Archibugi, Denni, and Filippetti formance. They have served as the locus for (2009). According to this consolidated set of integrated industrial clusters that share a rankings, the first place is assigned to Swe - common labor pool, facilitate buyer-supplier den, followed by the United States, Switzer- relationships, allow collaboration between land, Finland, Japan, and Denmark. China firms to refine and develop technologies, and is ranked 42nd. Its ranking by the selected encourage joint efforts to create marketing, indexes range from 26th in the United information gathering, and training systems. Nations Industrial Development Organiza- Where cluster networking is taking root, it is tion index to 45th in the World Economic internalizing technological spillovers and, in Forum index, with other rankings clustered the most successful cases, providing a virtu- around 44th place. ous balance between competition and coop- Technology development and innovation is eration. To foster clustering, cities are relying a fairly recent focus of China’s development upon science parks, incubators, and exten- strategy; hence there are very few Chinese sion services; encouraging local universities firms that can be counted among the techno - to engage in research and to establish indus- logical leaders in their respective subsectors trial linkages; inducing venture capitalists and that are significant producers of intellec - to invest in SMEs in the area; and trying to tual property. Although the research infra- attract a major anchor firm, local or foreign, structure and numbers of researchers have that could trigger the in-migration of suppli- expanded many times over, quality, expe- ers and imitators. Higher-level governments rience, and the institutions that undergird have reinforced these initiatives with a vari- innovation, remain weak. Leapfrogging into ety of tax and financial incentives and invest - the ranks of the top five contenders in most of ment in infrastructure and urban services the indexes will depend upon the efficiency of (Yusuf, Nabeshima, and Yamashita 2008). China’s technology policies and the response Some industrial clusters, as in Zhejiang these policies elicit from the business sector, and Guangdong, materialized autonomously academia, and the providers of supporting from long-established traditions of entrepre- services. It will also crucially depend upon neurship and the strengths of local networks; the creation of an innovation system that is others came together mostly as a result alive to the global and open nature of innova- of initiatives taken by national and local tive activities and their locus in a number of governments (He and Fallah 2011; Fleisher cosmopolitan urban hotspots. and others 2010). In many instances, the attempts to create cluster dynamics failed even after a number of firms established The u rban Dimension of Technology production facilities at an urban location— Development these failures reflect the experience of cities Science and technology activities and indus- world-wide. That notwithstanding, dense trialization are primarily urban phenomena, urban-industrial agglomerations, some with and in East Asia, the most dynamic and networked clusters of firms, have been vital 168 china 2 0 3 0 for the growth of productivity, for stimulat- (Fan, Kanbur, and Zhang 2009). Inland cit- ing technological change, and for promoting ies are in a position to capitalize on favorable further industrialization by opening opportu- wage and rental gradients and, with suitable nities and crowding in capital and skills. investment, some could offer more affordable Three major urban-industrial agglom- housing, recreational amenities, and public erations—the Pearl River Delta region cen- services to attract knowledge workers and tered on Shenzhen, Dongguan, and Fos- high-tech firms. According to a recent study han; the Yangtze River region around the by McKinsey Global Institute (2011), China’s Shanghai-Suzhou axis; and the Bohai region mid-sized cities with excellent growth pros- in the vicinity of Beijing and Tianjin—have pects—such as Wuhan and Zhengzhou— spawned multiple clusters producing every- would be contributing more to GDP growth thing from toys, footwear, and garments to than the leading coastal megacities. computers, electronic components, autos, and software (McGee and others (2011). Further The r oad to innovation industrial deepening in these three regions is continuing, and industrial agglomerations The imperative of building domestic innova- also are expanding in a number of the inland tive capacity is entwined with the dynamics cities, such as Chengdu, Chongqing, Xi’an, of knowledge diffusion and the large rents Hefei, Wuhan, and Shenyang. Some clus- that can accrue to lead innovators and first ters are evolving from industrial parks, such movers. Once a country is at the technologi- as the Zhongguancun IT cluster (Beijing), cal frontier and cost advantages have largely the Pudong pharmaceutical cluster (Shang- disappeared, producing and capitalizing on hai), and the Wuhan opto-electronics cluster a steady stream of innovations provides a (Hubei Province), but most clusters are still degree of insurance against economic stagna- operating at the lower end of the industrial tion. A compelling finding that has emerged value chain and lack horizontal integration from the analysis of patent data is that the (Zeng 2010). intricacies of the research techniques under- Despite the rapid pace of industrial lying new findings are transferred, often agglomeration nationwide, significant through personal communication, among a regional differentials remain between coastal small number of researchers, because they and inland cities. Productivity (measured by are tacit and not ready to be codified. The the GDP output per labor force) of the East circulation of new findings among firms in region is almost twice that in the Middle a cluster and between universities, research region and thrice that in the West region institutes, and firms proceeds slowly and can (annex table 2A.10). Scientific and techno - take three years or more, depending on the logical advances measured by patenting also nature of the technology, the type of firm, are much higher in the coastal regions (annex and expenditures by firms on R&D. A sub- table 2A.11). stantial body of research indicates that a few Technological capabilities and innovation cities account for a high percentage of innova- would certainly benet f fi rom a greater partici - tions and that these cities share certain attri- pation of major cities in the inland provinces, butes that make them “sticky” for knowledge many of which have substantial manufactur- networks and clusters. The persistence of ing capabilities, growing stocks of human this tendency despite great advances in com- capital, and strong tertiary institutions. A munications presents a strong case for invest- two-pronged approach that stimulates inno- ment in research to push the technological vation in coastal urban areas and cultivates frontier and to grow innovations locally in more specialized expertise in the leading sticky cities. The challenge for China is to inland urban centers would increase the likeli- arrive at a national innovation strategy that is hood of achieving growth objectives and also cost efficient, optimally decentralized, ratio - serve to reduce income and productivity gaps nally sequenced, and urban-centric. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 169 GEM (Growth Enterprises Market) in Shen- Assets zhen has provided innovative firms with an In its pursuit of innovation as a driver additional channel through which to access of growth, China starts out with seven financing and to give investors an exit route. advantages: A fourth advantage derives from China’s First, the scale and wide-ranging capa- successful penetration of the global market, bilities of China’s manufacturing sector are increasingly complemented by the expanding reaching the point where products can be market of domestic urban middle-class con- reverse engineered and new product lines sumers (Cheng 2010; Kharas 2009). A large brought into large-scale production within domestic market attracts multinational cor- months. This is being aided by the co-loca- porations and innovators, allows domestic tion of R&D and manufacturing in China’s producers to attain scale economies, and per- leading industrial centers, which are pro- mits the formation of clusters and agglomera- viding the foundations of a robust innova- tions that contribute to the competitiveness tion system. Advanced countries faced with of firms. It tests and winnows products and a hollowing of their industrial sectors are services and rewards winners. China’s mid- rediscovering this complementarity: once dle class is expected to double in the coming manufacturing capacity is severely eroded, decade and to double again in the next (Bhidé the skills and capabilities undergirding inno- 2008; Zhou 2008). Foreign firms first vation are also imperiled. flocked to China because it was an attrac- Second, having expanded its education tive platform for low-cost manufacturing. system, China’s efforts to innovate will be During the past decade, however, the widen- buoyed by the large supply of scientific and ing Chinese domestic market (and weakening engineering skills, which is adequate to meet demand in their home markets) has added the demand for high-level skills. This demand to the appeal of investment in China for is likely to remain strong, unlike the case in their existing product lines and for new Japan, for example. Moreover, the increas- offerings. ing attention to the quality of schooling at Fifth is the pro-business, entrepreneurial all levels, including the programs to develop culture (staunchly backed by local authori- world-class universities, will reinforce the ties) in the Pearl River Delta, Zhejiang, benefits from supply (Yusuf and Nabeshima Fujian, and elsewhere that is supportive of 2010). Shanghai’s top-ranked performance small firms and start-ups. Entrepreneurship in the 2009 Programme for International is not synonymous with innovativeness (De Student Assessment (PISA) tests provided Meyer and Garg 2005), but it can become a an inkling of what can be achieved through precursor as ideas and opportunities multiply. focused attention to raising quality of pri- State sector reforms initiated in 1996–97 led mary and secondary schools. Similar prog- to the exit, privatization, restructuring, and ress in the quality of tertiary-level graduates corporatization of thousands of state and col- nationwide would provide a quicker boost to lective enterprises and galvanized the private innovativeness and productivity (Hanushek sector. Since then, there is ample evidence of 2009; Pritchett and Viarengo 2010). entry and exit of private firms and of small The third asset is the elastic supply of and medium publicly owned firms under con - patient capital to support innovative firms, ditions of often intense competition, local which are currently in need of risk capital, and foreign. This is conducive to innova- and new entrants attempting to commer- tion—initially, most firms are focused on cost cialize promising ideas. Venture funds and innovation and customization for the domes- China’s private and state-owned banks are tic market, but that can change. Companies meeting some of the demand, especially in such as Huawei, ZTE, and Suntech can serve the coastal areas of the country, but a gap as role models for other domestic companies in funding remains. The creation of China’s seeking to become more innovative. 170 china 2 0 3 0 The sixth advantage is the potential Speed Bumps inherent in China’s still underdeveloped and relatively unproductive services sector. The These several advantages are counterbalanced technology and productivity gaps in ser- by a number of challenges and constraints: vices are particularly large as are the oppor- First, China’s macroeconomic policies tunities for innovation. With the services need to encourage the growth of the domes- sector expanding robustly and set to over- tic market rather than continue to focus take industry during the next decade, the industrial attention mainly on exports. An low-hanging fruit with regard to growth, increase in domestic household consumption productivity gains, and employment is (currently accounting for a little over one- increasingly tilting toward the services, trad- third of GDP) will have a positive impact on able and nontradable. Thus far, services such indigenous innovation meeting the needs and as education and health care are largely non- desires of Chinese buyers. tradable, but IT-related and other techno- Second, China’s SOEs control a huge logical and process-related advances could amount of physical assets as well as human lead to breakthroughs. Indigenous innova- talent and have yet to realize their full poten- 78 81 tions in marketing, online sales, after-sale tial for innovation. Lack of competition or services, and IT services, to name just a few, effective corporate governance means that are already on the rise, with many new firms some SOEs are indifferently managed and entering the market. If the trend strengthens less receptive to strategies that give primacy and leads to the emergence of a few national to growth through innovation. Even when giants as is happening in the United States SOEs invest in R&D—which many are doing and Europe (with increasing activity among under pressure from the state—the effort multinational corporations), and if inno- tends to be unproductive and poorly inte- vation intensifies (assuming no easing of grated with the rest of their operations. Com- innovation pressures), productivity gains in pared with smaller enterprises, the SOEs are services could begin to equal or overshadow not as efficient at converting resources into those arising from manufacturing. patents and innovations (annex tables 2A.12 Seventh, and finally, not only is China and 2A.13 for the industrial sector, annex urbanizing but, relatively early in the game, tables 2A.14 and 2A.15 for high-tech indus- some Chinese cities are realizing that the tries only). Annual growth of total factor productivity and growth of urban econo- productivity in the state sector averaged 1.52 mies will rest on the quality of life and the percent compared with 4.56 percent in the resilience of cities. These factors are a func- nonstate sector. Extracting high returns tion of urban design, the adequacy and effi - from R&D requires managerial ingenuity ciency of hard and soft infrastructures, the and experimentation with organizational testing and adoption of green technologies, structures; incentives; integration of research, environmental quality, affordable housing, production, and marketing activities; and a and the effectiveness with which cities—or long time horizon. Many small and medium entire metropolitan regions—are managed companies complain that some large compa- and decisions coordinated. An urban devel- nies, including large SOEs and multinational opment strategy, the objective of which is corporations, are abusing their market power to build efficient, green, and innovative cit - by favoring their own connected companies ies, will create enormous opportunities for and excluding other companies. Such favorit- innovation in urban planning, metro trans- ism inhibits innovation by other companies. portation systems, and green technologies. Third, China’s universities, particularly Successful innovation will be a function the leading ones, are adding capacity and of both national strategy and its elabora- giving greater attention to research and its tion and regional implementation (Howells commercialization, but the procedures for 2005). recruiting faculty with superior qualifications c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 171 from domestic and international sources by governments and solely state-owned invest- could be improved, and many university ment institutions accounted for less than faculty members need more experience. 40 percent of the total amount raised by Moreover, the quality of research is low, and China’s venture capital industry in 2010 there are worries that faculty members in the (Wang, Zhang, and Zhao 2011). However, leading research universities are distracted more support to newly created companies is from teaching by the financial rewards and still required. In the meantime, entrepreneurs recognition they gain from consulting, pub- continue to lack the mentoring, professional lishing, and patenting. Widespread concerns assistance, networking links, and market have been raised about research ethics and insights that are invaluable for young firms. the rigor of peer review of publications and Moreover, some venture capitalists complain projects. Heavy pressure on researchers that exit is hindered because it takes too long to produce and to collectively raise China’s for companies with venture-capital backing standing in the world is leading to dysfunc- to be listed on the GEM. tional outcomes. The scarcity of talented Fifth, Chinese firms need to work closely young researchers is also an issue confront- with multinational corporations to build ing universities as they attempt to recruit innovation capabilities, and it is in the inter- individuals with foreign PhDs or overseas ests of both parties to create a robust inno- experience. The tendency to tenure full pro- vation infrastructure. But the multination- fessors from overseas institutions encourages als may hesitate if they have to worry about others to spend their most productive years intellectual property protection, exclusion abroad. Furthermore, although universi- from government contracts, newly intro- ties have embraced the “third mission” of duced indigenous standards, rising domestic commercializing technology, the effects of content requirements, and pressure to trans- university-industry links on technological fer technology to China in exchange for mar- change have been minimal. Wu and Zhou ket access (Hout and Ghemawat 2010). Inno- (2011, 2) maintain that “the key role of uni- vation policies need to establish greater trust versities so far centers not so much on cut- between the government and foreign inves- ting edge innovation but on adaptation and tors and stronger institutions that validate redevelopment of existing foreign technology and operationalize the mutuality of interests. and products. . . . The contribution of UILs Western European experience starting in the [University Industry Linkages] as a part of 1960s suggests that, once such trust in insti- university R&D income was largely stagnant tutions is established, technological transfer in absolute amount and declined sharply as a and spillovers begin to rise and multination- proportion of the total R&D income during als begin to localize their latest production the 2000s. . . . The third mission of universi- techniques. The European experience differs ties seems stalled.” This conclusion is consis- from that of developing economies. Given tent with other observations, noted above, China’s size and long-term importance for regarding the current state of innovation in multinationals, however, China can learn China. from Europe and invest in the institutions, Fourth, China’s venture capital industry business practices, and cultural mores that is relatively inexperienced, as are other pro- undergird rapid technological diffusion. Chi- viders of services to start-ups and growing nese initiatives in these areas will be most high-tech firms. Moreover, even with the fruitful if they are matched by a greater emergence of local private firms and the entry readiness to cooperate on the part of for- of foreign firms, the venture capital industry eign companies in the pursuit of technology remains dominated by government-funded development. or -controlled companies (Zhang, C. and Sixth, although the benet fi s of smart (and others 2009). This situation is being cor- green) urbanization are becoming appar- rected, and the amount of capital contributed ent to many, much urbanization in China 172 china 2 0 3 0 is proceeding inefficiently and untidily, and resources while generating few spillovers; characterized by low-density sprawl, rib- in time, these shortcomings contributed to bon development along new highways, real the collapse of the Soviet economy. estate speculation, rising costs of housing The time for a hard look at innovation (with low-income households increasingly strategy and policies is now. disadvantaged), and neglect of long-term urban financing needs. These tend to hin- Defining Policy Priorities der productivity, making it harder for cities to support an ecosystem of small businesses China is embarked on a longer-term strategy that are the lifeblood of urban economies aimed at achieving technological parity with and a major source of innovation (Glaeser the advanced countries, and at deriving more 2011). Furthermore, the absence of longer- of its growth impetus from higher productiv- term fiscal planning jeopardizes urban ity across the spectrum of activities and by sustainability. capitalizing on the commercial benet fi s from Seventh, the signature characteristic pushing the technology frontier in selected of innovative economies is a learning and areas. Recent gains in technological capac- research environment that encourages new ity suggest that China is approaching the ideas and lateral thinking and that relies stage when it can transition to an innovation- on market signals to guide the direction of and productivity-led growth path. How innovation. In this model, the public sector quickly it makes the transition will depend plays a facilitating role, seeding experimental on strengthening the institutions that pro- research with a long-term payoff, providing vide incentives to entrepreneurs, scientists, the legal and regulatory institutional scaffold- and engineers in companies, universities, and ing, and establishing enforceable standards. research institutions to be more innovative. China is some distance from this model of an Thus, priority should be placed on loosening open, cosmopolitan, market-directed innova- institutional constraints. tion system. It may well be that the dirigiste This transformation is likely to occur in approach adopted by the Chinese state could two stages that will require shifting the pol- deliver the goods with respect to innovation, icy focus between the first stage and the next as it appears to be doing with technological (this division of stages is only for the pur- catch-up. China is putting fairly big bets on a poses of illustration). In the first stage (2011– number of technologies even as an innovation 20), China will continue to benefit from system is being pieced together, and without imported technologies, supplemented by thoroughly evaluating the returns from R&D domestic incremental innovation, to increase spending or the merits of recent policies to productivity, and to deliver rapid economic spur innovation. The development of science growth. An emphasis on further reforming and technology for the purposes of innovation SOEs, improving the quality of the work- remains a planned activity on an expanding force, encouraging applied research in firms, scale spanning multiple sectors with a lot at strengthening the research infrastructure, stake and considerable uncertainty regarding and building market institutions to sustain the future productivity gains. the tempo of competition and facilitate the The experience of the former Soviet Union entry of SMEs may be appropriate. During with its planned approach to technology this stage, China should achieve the trans- development focused on the defense sector formation from the planned national innova- argues for caution. The Soviet Union achieved tion system to a system that is open, global- near parity with the United States in many ized, market oriented, and compatible with a areas of weaponry, but because the defense market economy. The government needs to industry and its research were isolated from increase investment in basic research, push the rest of the economy, it soaked up talent through university reform, raise the skill c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 173 quality of its scientists and technologists, 3. Building national research consortia and and launch large science and technology pro- networks grams targeting some of the weak links in 4. Improving the productivity and quality key industries. of tertiary education with the help of IT In the second stage (2021–30), China and other innovations will derive more of its growth impetus from 5. Strengthening technical and vocational home-grown innovations that rely not only skills to fully exploit technical advances on the generation of ideas through cutting- 6. Tightening integration of a more produc- edge basic research—with risky blue-skies tive national innovation system with the research supported by the state—but also global innovation system on the harnessing of these ideas by dynamic 7. Sustaining an increase in R&D spend- Chinese multinational firms with global ing to raise the productivity of a national brand recognition, which are technology innovation system leaders in their own particular areas, com- 8. Enabling policies and rigorous evalua- mitted to achieving competitiveness through tion and refereeing of research programs innovation, and able to engage in technologi- to raise the quality of outcomes and to cal exchanges and partnerships with foreign maximize productivity benefits firms on equal terms. In attaining such lead- 9. Increasing access to risk capital and men- ership, Chinese companies will necessarily be toring of start-ups and SMEs by suppli- harnessing worldwide innovation resources ers of venture financing much like their foreign counterparts. 10. Using effective and disciplined gov- As indicated earlier, policies for the first ernment procurement to stimulate stage necessarily overlap with those for the innovation second. The difference is in emphasis. Sev- eral of the policies listed and discussed below 1. Deepen r eform to Develop a are frontloaded because the building of the Competitive Market innovation ecosystem is concentrated in the balance of the decade with the government A competitive market environment is a playing a lead role. In the second stage, the necessary condition for steady improvement burden of success will rest on the microstruc- in productivity. Creating this environment ture of the business sector, which is why a entails the opening of product markets, sub- competitive environment and investment jecting SOEs in the pillar industries to com- promoting macrostability are of paramount petition from private firms, enforcing, fairly importance. National technology and inno- and effectively, laws regulating competition, vation policies will need to be complemented and protecting intellectual property as well by urban policies that recognize the vital as consumer rights (Owen, Zheng, and Sun role of cities in advancing ideas, extracting 2007; Oster 1999). It also extends to com- the maximum mileage from existing general petition and ease of mobility in factor mar- purpose technologies, and helping germinate kets. Starting in the late 1980s, for example, new green technologies. The roles of the vari- market-oriented reforms stimulated entry ous entities involved are further spelled out in and competition in most manufacturing annex table 2A.16. subsectors. Even in some strategic, or pillar, industries (for example, airlines and tele- 1. Increasing market competition aided communications), the breaking up and cor- by greater national market integration, poratization of incumbent providers in the which promotes specialization of pro- 1990s released additional competitive pres- duction and research activities sures. More recently, the phasing out of tax 2. Making enterprises play a pivotal role in incentives, which had favored foreign inves- the national innovation system tors, stimulated competition by leveling the 174 china 2 0 3 0 playing field with domestically owned firms. 2. enterprises Have a Pivotal r ole in the China’s WTO accession in 2001 increased National innovation System competition from imports, and the large volume of FDI has led to a further intensi- Innovation is essentially about creating fication of competitive pressures. Sustaining more wealth by discovering and using newer this trend through institutional reforms and methods. In all innovative economies, be measures to enhance the supply of risk capi- it the United States, the long-time innova- tal as well as the mobility of the workforce tion leader, or more recent entrants such as will be critical to the making of an innova- Japan and Korea, companies have success- tive economy. These steps will stimulate the fully created national innovation systems. deepening of the private sector, promote the Most of the applied research and innovation growth of dynamic SMEs, and induce the of consequence for the economy is done by SOEs to raise their game (and pave the way firms; in the United States, for example, for further reform). Greater national market the vast majority of scientists are employed integration would discourage local protec- by businesses and governments and not by tionism and lead to coordinated R&D activi- institutions of higher learning. Innovation ties at least by public entities—including uni- will flourish if firms in particular provide versities—thus minimizing the duplication of researchers with the freedom to pursue inter- suboptimally scaled research and the waste esting ideas in a stimulating work environ- of resources it entails. It would mean intensi- ment (Shapin 2010). Mani (2010, 15–16) fying the degree of competition and churning notes that, “due to various historical and among firms, encouraging firms to compete structural reasons, the efficiency and inno - on the basis of technology, and promoting vation capacity of the business sector is still much needed regional or local industrial and insufficient, despite a large and rapid increase research specialization. in scale and scope.” Mani uses a crude mea- Competition and market integration is sure of firms’ ability to develop local tech - inseparable from the efficient pricing of fos - nological capabilities as the ratio of intra- sil fuels (with carbon taxes added to reflect mural R&D in business enterprises to the externalities), electricity, and other nonre- cost incurred in technology purchases from newable resources as well as the setting of abroad. Over 1991–2002, China’s average national standards (including environmental propensity to adapt grew from less than unity standards and standards encouraging energy to only about 1.5 in 2002. efficiency) for products and the enforcement Government can support enterprises in of these standards. This will also generate developing technological capabilities and pressures to upgrade technologies, which producing innovative products by establish- some western countries have done to good ing research and development platforms for effect. Strengthening the industrial exten- the use of those companies. In China, there sion system and providing smaller firms are a range R&D platforms and business ser- with easier access to laboratory, metrology, vice providers such as engineering research testing, and certification facilities would centers and productivity centers, but many facilitate meeting these standards by smaller of them lack the market orientation and the firms. The German Fraunhofer Institutes pro - close involvement of potential employers vide a model for China to adapt. In Japan, in the design and teaching of curricula and the TAMA association makes laboratory suffer from shortages of funding and expe- facilities and testing equipment available to rienced trainers. It is important to make its member firms, most of which are small or them more functional and more respon- medium in size. The association also offers sive to the needs of the economy through a assistance in obtaining product certification public-private partnership approach. And and in creating web pages for purposes of there are some good examples of public plat- advertising, among other services. forms that could be more widely replicated. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 175 FiGure 2.2 Shanghai r &D Public Service Platform Shanghai R&D Public Service Platform Science and Equipment Testing Base Industry Testing Entrepreneuring Technology Literature Sharing Cooperation Service System Service System Service System System System Professional Technology Management Scientic Figure Resources Security Technology Transfer Service Decision-making Sharing System System Service System System Support System Source: Shanghai Municipality Science and Technology Commission 2006. For example, Shanghai’s R&D public service improvements in management and the cor- platform offers a wide range of business and porate culture, China may struggle to absorb extension services that cover the innovation technology at the desired pace and thus to development process from the sharing of sci- make the leap from catch-up to a regime of entific information to technology testing and steady innovation. transfer services to support for entrepreneur- ship and management (figure 2.2). 3. Build Nationwide r esearch and The influx of FDI and the recent brain Development Networks gain is helping to enhance managerial experi- ence as well as technical, research, and teach- The central government can take greater ing skills, but a significant shortfall persists. initiative in building countrywide research To move forward, both the private sector networks that mobilize national talent and and the government need to invest more in reduce the relative isolation of inland cities improving human resources, especially the by including firms from the inland cities in management of state-owned and private research consortia tasked with disseminating enterprises, in order to build and embed a the latest technologies and advancing tech- culture supportive of innovation. Too many nology in areas where they have an existing Chinese senior managers from companies or nascent comparative advantage. Such with global ambitions lack formal manage- consortia have been sponsored by govern- ment training, and most are deficient in Eng - ments in Japan and the United States, and lish language skills. They tend to rely more they can help China develop more “global on informal networks to gather information challengers” including from the inland and on intuition and instincts in making deci- metropolitan regions. Successful regional sions. As a consequence, firm-level research innovation systems are associated with uni- and innovation strategies can be haphazard versities that conduct some of the upstream and do not systematically engage the relevant research and generate ideas; a mix of smaller departments of a firm, little effort is made firms that often take the lead in introduc- to gather and analyze data to evaluate results ing new technologies with mentoring from and to guide decisions, and interactions with venture capitalists and angel investors; and foreign firms—including foreign travel—are larger firms with resources to perfect, scale too often delegated to junior staff. Absent up, and market the commercial outcomes of 176 china 2 0 3 0 these technologies. Recognizing the cost techniques that favor lecturing over discus- and complexity of research in frontier fields sion and greater classroom involvement (especially green technologies), even the larg- of students; and university systems poorly est firms are finding it desirable to specialize equipped to exercise quality control and and to form partnerships with other firms or to weed out weaker candidates. In the with universities when developing sophisti- meantime, employers complain of a serious cated new products or technologies. Through shortage of highly skilled technicians, engi- a pairing of inland firms with more advanced neers, and executives. This low-skill glut firms from the coastal cities (including multi - and high-skill shortage poses a difficulty for national corporations), the research potential the skill transfer needed for companies to of the interior would be more fully exploited improve the quality of their output or move and technological capabilities enhanced. In to a higher rung of the value chain. addition to consortia, the technological and Because the demand for tertiary education innovative capabilities of inland cities would is likely to keep rising and because quality benefit if both domestic and foreign firms will remain a major issue, China’s universities could be persuaded to locate some of their will have to consider some disruptive innova- R&D centers in these cities, and not just tions of their own in order to provide cus- production facilities. This process is already tomized education for a vastly larger body of under way in Chengdu and Xian, for exam- students at an acceptable cost (Christensen, ple, but its success will depend on regional Horn, and Johnson 2010; Zhong 2011). It innovation policies actively pursued by local must be recognized, however, that there is no governments, which must provide the incen- simple technological fix. Universities are tives and build the institutions tailored to more likely to embrace change if they enjoy local needs. Inland cities with a research a measure of autonomy for their own gov- orientation would benefit from a focus on a ernance, modes of instruction, curriculum few specific industries, and, depending on design, hiring, salaries, course offerings, and what kind of activities achieve prominence, research orientation; are induced to compete governments would have to act accordingly: and collaborate with universities through- developing a research-based biotechnology out the country; and supplement traditional cluster would require very different policies lecture-based training with new pedagogical from an engineering or a food-processing or practices and online and IT tools (especially a white goods cluster. now that great advances in video links have advanced to a point where a virtual seminar is becoming a reality). Universities will 4. improve the Quality of Chinese need to recruit faculty from among some of u niversities China’s brightest graduates, many of whom China’s universities are graduating millions will be inclined to pursue careers other than of students each year to meet the needs of teaching. They will also need to tailor the knowledge economy. An estimated 6.6 course offerings, instruction, and research to million, including more than 50,000 with instill the desired mix of technical and soft doctorates, entered the job market in 2011. skills (communication, team working, report But the quality of the training is weak, and and business plan writing) as well as the many graduates are having difficulty find- industry know-how in the greatest demand. ing employment, although this is likely to be Perhaps the greatest challenge is how to temporary. The low quality is explained encourage creativity and initiative, attri- by four factors: the massive expansion of butes that are urgently needed as the country enrollment, which has strained instructional strives for technological maturity. capacity; the short duration of PhD train- By harnessing IT and tapping the exper- ing (three years); the inexperience and weak tise and resources of leading firms, universi - qualifications of instructors and pedagogical ties can improve teaching, motivate students c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 177 to stick with demanding courses, limit the Germany, Switzerland, and Finland, between escalation of costs (which is crippling schools one-fourth and one-half of all secondary in many advanced countries), and help equip school students take the vocational and tech- universities with the infrastructure they need nical route to a career in industry rather than to fulfill their missions. China’s front-ranked opting for general education. Striking a bet- schools must also be able to mobilize the ter balance between the general and the tech- funding and staff faculty positions to offer nical would seem to be warranted. cross-disciplinary postgraduate and postdoc- toral programs and set up specialized, well- 6. Develop an Open innovation System staffed research institutes. Universities can provide the precursors to innovation through Investment in R&D facilities by multinational basic research that leads to discoveries and corporations is on the rise and needs to be novel findings. They can also incubate entre - further encouraged and facilitated because of preneurs and skilled researchers, who are its potentially significant spillover effects that the vehicles for transforming ideas into com- can enrich the knowledge and experience of mercial products and services. Together, the the Chinese workforce, the potential gains in government and universities can enhance the reputation for Chinese cities that will come to dynamism and innovativeness of the private be seen as science hubs, and the contribution business sector. such research can make to industrial upgrad- ing. Closer collaboration and partnerships with multinationals on the basis of mutual 5. Strengthen Vocational Training trust and recognition of the interests of both The development of high-tech industry envis- parties will contribute greatly to the creation aged by the 12th 5YP depends upon an of a dynamic and open innovation system. increased supply and upgrading of technical The size and future growth of China’s mar- skills through in-house training and voca- ket means that many multinationals will be tional schools. Workers need to be trained shifting the primary focus of their operations in a vast range of technical skills to staff fac- to China; as a consequence, technological tories, engage in technically more demand- spillovers are very likely to increase. In this ing tasks as innovation ratchets up the level context, an efficient patenting system that of industrial complexity, render IT support, reflects the experience of the U.S. and Euro - maintain and repair complex equipment, and pean systems (both of which are in the throes provide myriad other inputs and services. of reform) and effective protection of intel- Smaller firms and start-ups frequently have lectual property will expedite the growth of difficulty finding such skills and can rarely China’s innovation capabilities (Smeets and afford to provide much training in-house. de Vaal 2011). Gwynne (2010, p. 27) writes Hence, public-private initiatives are required that “even companies that possess legitimate to secure and replenish the base of technical Chinese patents have had problems defending skills essential for a smart city; aside from their rights, because the scope for protection minimizing both frictional and structural is much narrower. . . . And when it comes unemployment, these initiatives can antici- to enforcement, only [recently] have there pate market failures and promote desirable been any large damage awards for infringe- forms of industrial activity. Labor market ment.” Legal developments in the form institutions can be strengthened and made of specialized intellectual property courts is nondiscriminatory by setting up multilevel changing the picture. It is also undeniable professional advisory agencies and by increas- that China has made substantial progress in ing the provision of vocational training to protecting intellectual property rights in fur- meet the demand from expanding and new therance of its ambition to become an inno- enterprises. In the most innovative and indus- vative country. Not only did China launch trially dynamic European countries such as reforms in 2008 to support the creation, 178 china 2 0 3 0 utilization, management, and protection of government-sponsored research and con- intellectual property, but it may be the only tests to develop particular types of technolo- country to have criminalized violations of gies would be to make the findings of this intellectual property rights. As more and research widely available. In the 1950s and more Chinese firms file court cases charg- 1960s, the research on electronics financed ing violation of their rights by other Chinese by the U.S. government was shared gener- firms, the awareness of intellectual property ously with private companies, which enabled protection will be further raised and protec- many companies to come up to speed and tion rendered more effective. Furthermore, become innovators themselves. the Chinese government has recently relaxed Although an increase of one percentage some government procurement restrictions point of GDP in R&D will be one strand of on multinationals, which should encourage China’s growth strategy, the enabling char- these corporations to establish R&D centers acteristics of the domestic macroeconomic in China. The government could also encour- and business environments will be decisive if age home-grown multinationals to partici- China is to maximize the longer term returns pate in international R&D and integrate into from R&D spending. Comin (2004) esti- global innovative networks. mates that in the postwar period, R&D con- tributed between three-tenths and five-tenths of a percentage point to productivity growth 7. Strengthen Basic r esearch to Sustain in the United States. That higher R&D need Continuous Support for innovation have only a limited effect on growth is also Central and provincial governments in China apparent from the experience of Sweden, Fin- are seeking to enlarge the share of basic land, and Japan (Lane 2009; Ejermo, Kan- research in universities and research insti- der, and Henning 2011). tutes as well as to raise the profile of R&D in firms, thereby building research capacity 8. Create a Stringent and Disciplined throughout the country. They are more Process to evaluate and r eferee likely to succeed by committing a sufficient r esearch Programs and Findings volume of funding and ensuring the continu- ity of funding, with the help of an enabling This is a difficult but unavoidable activity. As macro policy environment, and through Lane (2009, 1274) observes, “The relation a systematic evaluation of programs. The between science and innovation is nonlinear U.S. government proactively supported agri- in nature, with complex outcomes that can cultural research starting in the mid-19th vary substantially by discipline and are sub- century and even through the 1930s, most ject to considerable time lags. . . . Innovation public research funding served to promote is nonlinear because the demand side and the agricultural productivity. More recently, the supply side of ideas are inextricably inter- National Institutes of Health have played the twined.” It is an activity requiring initiative central role in the boom in the life sciences in from the research community, particularly the United States because they were and are in strengthening research ethics, institut- a source of large and stable funding, much ing strict penalties against plagiarism, and of it for basic research done in the universi- strengthening the independence and qual- ties. This funding financed countless research ity of the refereeing process. However, programs, trained thousands of PhDs, sup- the government could provide some of the ported postdoctoral students, and created parameters and adopt a different approach the depth of expertise that has enabled the to high-risk research (as is the case in the United States to become the leader in the field United States with the National Institutes of of biotech. TEKES and SITRA in Finland Health Pioneer and New Innovator Awards, have also contributed along similar lines. and the Department of Energy ARPA-E One way to maximize the spillovers from program ), which promises to break new c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 179 ground. Such projects should be evaluated and others 2011). The weight of leadership by their potential for transforming a subfield. and the engagement of the National Devel- More broadly, the management and evalua- opment and Reform Commission and the tion of R&D in China requires considerable Ministry of Finance would also increase enlightened strategizing and management by the commitment of subnational govern- public agencies. ments to the innovation agenda and lead The development of innovation capacity to the strengthening of regional innova- in China since the mid-1990s has involved tion systems. multiple agencies, and numerous policies • Leadership and coordination must go have been introduced. Looking ahead, with hand in hand with a concerted effort to the focus on innovation sure to sharpen, the raise the technical and implementation tempo of policy making can only increase, skills of the government bureaucracies and the economic outcomes will depend sub- tasked with driving the innovation strat- stantially on the quality and timeliness of egy. It almost goes without saying that the policy interventions. If past experience the growth of innovation capabilities will from other countries is a reliable guide, these demand considerable farsightedness, agil- policies will be multiagency and multidis- ity, and innovativeness on the part of those ciplinary, relying upon a mix of tax, fiscal, responsible for guiding and managing a financial, and regulatory instruments. Good highly complex endeavor during a cru- policies will depend upon: cial stage of gestation. The quality of the bureaucracy matters everywhere; however, • Strong leadership by the Communist Party given the large role played by the state in Central Committee (CPCC)/State Coun- China, the importance attached to build- cil, by strengthening the leading group ing innovation capacity in the shortest on Science, Technology, and Education, possible time and the vast resources being headed by the premier, which would have invested, the caliber of the bureaucracy the requisite authority. takes on an added significance. • Direct and consistent involvement of the • The experiences of the most innovative National Development and Reform Com- countries—such as Finland, Israel, the mission, Ministry of Finance, and Min- United States, and others—none of which istry of Science and Technology, the key can boast an unimpeachable innova- ministries involved with innovation poli- tion system —underscore the contribu- cies, and effective coordination of their tion that a sound process of evaluating roles. research-related spending can make to the • Effective horizontal communication and design and conduct of innovation policies coordination among other major minis- and to raising system productivity. Econo- tries engaged in the making and imple- mists have generally tended to give high mentation of S&T policies, such as the marks to R&D spending, claiming that it Ministry of Education, the Ministry of generates exceedingly high rates of social Commerce, the Ministry of Health, the and even private returns, usually higher Ministry of Industry and Information than spending on fixed assets. But on Technology, the Ministry of Agriculture, closer scrutiny, it appears that many of and others. The leadership role of a CPCC these claims might be exaggerated. Ben leading group would minimize past frag- Martin the editor of Research Policy mentation of decision making among observes that not infrequently, “there is agencies, each of which pursues a narrow some PR [public relations] rather than policy agenda within its own particular rigorous research involved.” Measur- silo, as well the conflict among roles and ing the inputs and outputs of research is mandates, thereby achieving greater policy not a trivial exercise. The benefits from coherence and effectiveness (Liu, Simon, research are uncertain and variable and 180 china 2 0 3 0 they accrue over a long period of time. still scarce. Moreover, the level of profession- Moreover, the bulk of the returns take the alism and experience of venture capitalists form of spillovers for which there are no and the degree of trust between providers of good metrics. The problem is especially risk capital and borrowers is still fairly low; severe with basic research. There are costs hence, further development of risk financ- to research results and their assimilation, ing by venture capitalists and business angels which can come to light much later and will be needed. Banks can serve as a partial need to be factored in. For example, new substitute, but such lending is rarely their medical technologies that extend the lives forte. Nonetheless, such lending on a limited of elderly patients impose costs on society, scale by local banks to local firms and the nuclear power has imposed cleanup and creation of bank-led relational networks is a disposal costs, and many defense technol- mode of financing that seems to work in the ogies have not been unmitigated blessings. United Kingdom and the United States and Collecting data on inputs and outputs complements the resources of entrepreneurs, from myriad and disparate sources and angel investors, and venture capitalists. Too making the data consistent and readable is little bank financing in China goes to private an additional and daunting task. Once the firms and especially the riskier high-tech ones data are gathered, selecting an appropri- (Hanley, Liu, and Vaona 2011). That said, ate methodology for analyzing them pre- the dot-com bubble and other bubbles have sents a further challenge. But all this is highlighted the waste arising from bouts of unavoidable in view of the sums involved irrational exuberance fed by an excess of risk and the need to obtain the greatest pos- capital. The enormous investment in specula- sible productivity mileage from public tive real estate both in China (amounting to spending on the innovation system. The 12 percent of GDP in 2010) and in countries lesson from advanced countries is to start with sophisticated financial systems suggests early by putting in place a system to rap- that capital is not necessarily the constraint; idly evaluate research spending, to absorb more often it is investors who are rightly the learning promptly into the policy- skeptical of technological offerings with making process, and to be ready to make uncertain prospects. Facilitating the exit for corrections or terminate programs that are venture capitalists is as important as raising not producing results. China is at the stage venture capital for start-ups and innovative where it can begin building the elements firms (Guo, Zhang, and Li 2000; Guo 2009). of an evaluation process into its emerging So far, SMEs have only limited choices to innovation system, learning from others raise capital by listing on stock exchanges, and fully utilizing the latest available data which normally takes a long time. gathering, storage, and analytic technolo- gies that promise to make a difficult task 10. Make Better u se of Demand-Side more manageable. Policies Demand-side policy instruments such as gov- 9. Develop Multilayered Capital ernment procurement and standard setting Markets to Support innovation and for equipment and services, combined with Start-ups adequate efforts to guard against protection- Rising demand for risk capital calls for an ist and rent-seeking activities that undermine increase in supply. The Chinese government market competition and discourage high-tech is active in promoting both public and private FDI, will stimulate the demand for innova- venture capital, at least in the coastal cities. tion (Liu and Zhang 2008; Zhang 2007). Although some public risk capital is available Managing government procurement is a inland, private venture capital for smaller relatively new domain of policy in China. private firms, which are trying to scale up, is The first national guideline for government c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 181 procurement was issued in 1999, and the innovative cities will be an important driver National People’s Congress adopted the law of China’s growth through innovation. in 2002. Despite the relative newness of this approach, the government’s determination innovation in Health Care to support innovation through procurement has been clear. However, procurement policy The salience of health care in the Chinese can be a double-edged sword. The key to economy is certain to increase, and innova- success lies in open competition. In China, tion will be an important mechanism for some potential risks in this area need to be controlling costs while raising quality and fully recognized and reflected in government expanding access to health care. Health care policies. These include the risk of turning the in China confronts a “perfect storm,” with government procurement instrument into steeply rising social and financial costs that one that protects national and local products could become a huge burden on the nation in from international and national competition a handful of decades. To quote from a Lancet and the risk of the government becoming editorial: a passive taker of what domestic suppliers offer, rather than a demanding buyer of tech- The population demographics are uneven, nologically sophisticated products (Zhang, exaggerated by rapid ageing, as a result C. and others 2009). of the single child policy, and by the large The demand for innovation could be number of highly mobile workers within increased through government standard set- the country. The health infrastructure is ting. Standard setting allows governments variable, with world leading medical cen- and other entities to generate demand for ters in the populous east of the country, advances in, for example, the performance, whereas more rural areas lack basic sani- safety, energy efficiency, and environmental tation. Despite better control, infectious impact of products. Measures that could be diseases still account for considerable taken to generate more demand for innova- morbidity with an ever-present danger of tion include focusing exclusively on prod- new outbreaks. Alongside communicable uct improvement and resisting the tendency diseases are the increasing burdens caused to use standard setting to protect or help by the diseases of afu fl ence and changing domestic or local industry; taking EU or U.S. lifestyles. Meanwhile the ability to deliver standards as a technical starting point while care is compromised by an uneven distri- looking for ways to advance product perfor- bution of human resources and the loss of mance; involving industry leaders more in doctors to other professions. In addition standard setting (but that needs to be done to the breadth of the challenges, the size in a productive way); and changing the role of the task is enormous. A Chinese man of government from sole standard setter to smokes one in every three cigarettes. 177 time-sensitive driver of industrial consensus million adults in China have hypertension (Zhang, C. and others 2009). but few receive effective treatment” The inexorable march of noncommunica- emerging Priorities for ble diseases is heightening concerns; these are innovation now responsible for 80 percent of all deaths As per capita incomes rise, China’s spending and 69 percent of the disease burden—higher on health care will increase in parallel. The than in the advanced countries—and they health care sector will become an impor- threaten to significantly erode China’s eco - tant sector for China’s economic growth nomic gains (World Bank 2011). David Cut- and social development. In addition, as hun- ler (2003) has estimated that high-income dreds of millions of people emigrate from countries can expect health care costs to rise rural areas, developing green, smart, and by 5.7 percent of GDP just on the basis of 182 china 2 0 3 0 demographic and technological changes. The it raises are lucidly discussed by West and increase could be greater in China given its Miller (2009). stage of development, rising incomes, chang- ICT can also help to contain costs by ing lifestyles, and epidemiological profile. enabling a much more exact measurement of Containing health care costs while providing total costs of care than is the case currently. modern health care to the entire population Providers and insurers have had only a rough promises to remain a long-term policy objec- idea of the costs of caring for a patient but tive. And the experience of advanced coun- now are in a position to track the type and tries points to the urgency of policy inter- amount of resources used over the course of a vention, before institutions have had time medical treatment (Kaplan and Porter 2011). to solidify and strong vested interests have Christensen, Grossman, and Hwang become almost politically invincible, as is the (2009) highlight another aspect of innova- case in the United States, Europe, and Japan, tions in the biopharmaceutical and diagnos- and the system acquires an immense status tic fields with potentially disruptive and cost- quo bias (Starr 2011). reducing effects. This is the rise of so-called Clearly innovation is only a part of the precision medicine tailored to the unique answer, and in fact some of the cost escala- genetic profile of each patient, which would tion is directly attributable to advances in sharpen the accuracy of diagnosis and ensure pharmaceuticals, diagnostic devices, medi- that each ailment is treated with the medica- cal implants, and others. But technologi- tions calculated to have greatest effect and cal improvements are also behind some of the fewest side effects. The cost savings the advances in the quality of health care from this set of innovations could be large. and increasing longevity (Lichtenberg 2008, To strike the best balance between the 2010, 2011). Among the innovations that quality of health care and costs, China will are likely to play a major role in the future, have to strive for medical innovation that is and that thus deserve the most prominence, tempered by effective regulation (which mini- are advances in preventive medicine, which mizes red tape, optimizes incentives for pro- reduce the risks from communicable diseases, viders, and fully harnesses ICT) and for com- ameliorate the effects of chronic ailments, petition among providers on results so that bring about positive changes in lifestyles, and more patients migrate to better providers. ensure that the majority of the population Porter and Teisberg (2006) note that “good has access to clean water and good sanita- quality is less costly because of more accu- tion. Some of these advances will involve bio- rate diagnoses, fewer treatment errors, lower pharmaceutical innovations, but many others complication rates, faster recovery, less inva- also will play a role. Digital medicine is set to sive treatments, and the minimization of the greatly expand its contribution by revolution- need for treatment. Competition on results to izing billing, ordering, record keeping and improve patient value is an irresistible force sharing, and medical administration. Digital for transforming the health care system with- medicine is also transforming access to medi- out the need for top-down government inter- cal information, communication between vention.” Greater competition in health care doctors and patients, and the monitoring of would be very much in tune with the over- patients by providers. Advances in distance all strategy to build a more competitive eco- medicine have the potential to multiply medi- nomic system. cal assets and are only beginning to be tapped through new diagnostic and other devices as Building Green, Smart, and innovative well as through the outsourcing of diagno- Cities sis. The potential of digital technology, how it can be assimilated (and the advantages of Investment in technological capacity is more early action), and the many ethical, proce- likely to result in a flourishing of innovation dural, administrative, and financial hurdles in a competitive environment and in “open” c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 183 cities (Hu 2011). Learning from its experience of knowledge workers drawn from all over with rapid industrialization in the 1980s, the country—and the world (Page 2007). China initially sought to enlarge techno- Moreover, such cities are closely integrated logical capacity in a small number of coastal with other global centers of research and cities (notably Shenzhen, Guangzhou, and technology development, and their teach- other cities in the Pearl River Delta as well as ing and research institutions must compete Shanghai and Beijing) with the help of FDI, with the best for talent and to validate their imported equipment embodying new tech- own ideas. For innovative cities, openness niques, licensing, and reverse engineering. and connectivity are more important than The decentralized urban-centered approach, scale. These contribute to the productivity bolstered by suitable organizational and of research and the generation, as well as the fiscal incentives and increased R&D, jump- validation, of ideas. However, urbanization started technology assimilation from abroad economies arising from size and industrial and created the framework for stimulating diversity can confer important benefits by indigenous technology development. On the offering a mix of technologies and production technological plane, these cities are perform- expertise out of which innovations can arise ing the functions that the Special Economic and that provide the soil for new entrants Zones provided in the 1980s. The proposed to take root. Connectivity through state- intensification of R&D activities during of-the-art telecommunications and trans- 2011–20 and the increasing emphasis on port infrastructure—airports in particular achieving technological parity with the West (Kasarda and Lindsay 2011)—is a source of and on greening growth to improve quality virtual agglomeration for an intelligent city, and minimize environmental costs offers an conferring the advantages of a large urban opportunity to develop the innovation capac- center without the attendant disadvantages of ity of coastal and some inland cities and, in congestion and pollution. In this respect, the the process, to increase the productivity of smaller innovative cities of Europe and the R&D expenditures. United States enjoy the advantages of livabil- Innovative cities rely upon the quality of ity without sacrificing the productivity gains human capital, on institutional mechanisms accruing from agglomeration. and basic research of a high order for gener- To exploit the innovation potential inher- ating ideas, and on ways of debating, testing, ent in virtual agglomeration, innovative cit- and perfecting these ideas and transforming ies need to actively network with other cen- them into marketable products. The innova- ters throughout the region and the world tive city achieves rapid and sustainable indus- and build areas of expertise. This calls for trial growth by bringing together and fully embracing a culture of openness, and activ- harnessing four forms of intelligence: the ism on the part of major local firms and uni - human intelligence inherent in local knowl- versities to translate such a culture into com- edge networks, of which research universities mercial and scientific linkages that span the are a vital part; the collective intelligence of globe. For a city to be recognized as an inno- institutions that support innovation through vation hotspot, however, one or a few local a variety of channels; the production intel- firms must join the ranks of the world’s lead - ligence of a diversified industrial base that ing companies in a technologically dynamic is a source of urbanization economies; and field and account for a sizable share of the the collective intelligence that can be derived global market. from the effective use of digital networks, Last but not least, because innovative cities online services, and face-to-face contacts in are at the leading edge of the knowledge econ- a conducive urban environment (Komninos omy, their design, physical assets, attributes, 2008). and governance need to ree fl ct their edge over The leading global innovative hotspots are others. Industrial cities can become innova- open to ideas and thrive on the heterogeneity tive cities, and a strong manufacturing base 184 china 2 0 3 0 can be an asset, as it is for Tokyo, Stuttgart, established industrial parks to provide space Munich, Seoul, Seattle, and Toulouse. But and services for industry to grow. These plus industry is not a necessary condition: Cam - a full suite of incentives satisfy most of the bridge (U.K.), Helsinki, San Francisco, and preconditions for the emergence of innovative Kyoto are not industrial cities, yet they are industrial clusters. What might be missing is innovative cities that have acquired signifi - an industrial focus on specialization and on cant production capabilities that are high- the quality of the environment. tech or “I-tech” (Markusen and others 2004). Cities become innovative when existing Greening u rban Growth industries or institutions act as a nucleus of new activities and start a chain reaction. The Economic growth that is largely urban driven process can be initiated by any of a number must be rendered climate friendly. Hence of catalysts—decisive and visionary leader- the “greening” of urban growth is becom- ship by leading stakeholders, the upgrading ing a priority worldwide, including in China. and transformation of a local university, the Although the precise meaning of green creation of a new research institution, the growth remains somewhat elusive, it points arrival or growth of a major firm, a small to the possibility of achieving sustainable cluster of dynamic start-ups, or some other urban development through a virtuous spiral catalytic event that energizes a combina- of innovations. At the core of green growth is tion of intellectual and productive activi- the assumption that the energy, capital, and ties. There are virtually no instances in the emissions intensity of GDP can be contained past two decades of innovative cities being or reduced as economies expand. The hope is successfully made to order anywhere in the that if greening can be mainstreamed, much world. The attempts to engineer science cities more can be achieved: a green growth strat- such as in Tsukuba in Japan and Daejeon in egy should lead to development of and invest- Korea as well as similar complexes in Europe ments in low-carbon technologies and infra- have rarely lived up to expectations. structures that bring about a green industrial The science and technology capacity of revolution, creating the jobs and raising China’s coastal cites is well established and incomes without the negative externalities is being steadily augmented through rising associated with the fossil fuel–based growth investment in the research infrastructure; of the past two centuries; greening can thus that of several inland cities is now being contain the trend change in the climate. An developed through increasing attention to exploration of the possibilities is still at an regional innovation policies. Cities such as early stage and hemmed in by the prevalence Xian, Chengdu, Zhengzhou, and Hefei are of entrenched technologies, but even now it attempting to raise the profile of their leading is obvious that if the revolution is to succeed, universities, grooming local firms that could much will depend upon the initiatives taken become industrial anchors for local clusters, by cities and the effectiveness with which much like ARM and Cambridge Consultants they are implemented. served as the anchors for the electronics clus- To realize the potential of green urban ter in Cambridge, U.K. Several cities such growth, a conceptual framework can usefully as Chengdu, Shenyang, and Chongqing provide the scaffolding for policies—national have also been successful in persuading mul- and local. In this context, an intersection of tinational corporations to set up production two concepts pertaining to general purpose facilities, which augment manufacturing technologies (GPTs) and to agglomeration capabilities and create the preconditions for economies can serve to identify and elaborate a concentration of the value chain. More- actions to promote green growth. over, leading inland cities such as Changsha Long cycles of growth-augmenting tech- are investing in the transport infrastruc- nological change are associated with the ture to improve connectivity, and all have emergence and diffusion of GPTs, which c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 185 have protracted and economywide effects. cities, inefficient services, and infrastructures A GPT has three characteristics (Bresnahan and transport systems that cater to ever- and Trajtenberg 1996): increasing automobility. Green urbanization suggests a number of policy directions: 1. Pervasiveness: It should spread to most sectors. • With respect to urban design, it would 2. Improvement: It needs to evolve and put a premium on the compactness of cit- improve over time with users benefiting ies and mixed-use neighborhoods with from steadily falling costs. due attention to and investment in public 3. Innovation spawning: The GPT should transport systems, green spaces, and rec- promote invention and provide the foun- reational amenities to reduce energy inten- dation for new products, processes, and sity as well as environmental pollution. related organizational and institutional • It would seek to more fully realize the changes. returns from urban real estate and sup- porting infrastructures while remaining Steam, electricity, the internal combustion mindful of urban congestion and with- engine, and now IT, are the emblematic GPTs out compromising individual intraurban (Jovanovic and Rousseau 2005). Each was mobility and the quality of urban life. and is responsible for urban industrialization • To deliver on its growth potential, green extending over several decades, requiring a urban agglomeration would need to be massive volume of investment. The effects hospitable to the continued vitality of were not limited to a single sector; instead, existing industrial activities (while pro- these GPTs unleashed innovations that dif- viding incentives for the greening of these fused through and energized the entire econ- activities) and to the emergence of new omy. The innovations shifted the production industrial clusters producing tradables so frontier; triggered sustained investment in as to generate net employment and a flow new products, business models, and modes of exports. of production; and served as the founda- • It would support the growth of urban tions of long-term economic growth. Start- industries and services producing for the ing in the 1970s, the benefits from IT began green economy: the adoption of energy filtering through the global economy and and resource-conserving technologies very likely will continue to stimulate innova- (such as smart grids, energy-efficient hous - tion and productivity for another decade or ing and consumer products) backed by two. However, the looming threat of climate standards, regulations, and pricing and change from accumulating greenhouse gases procurement policies plus consumer edu- largely released by urban centers (up to 80 cation campaigns that bring about a shift percent of the total) and the increasing press in preferences; of technologies controlling of energy and resource scarcities has created emissions and waste; and of techniques a need for new energy and resource utiliza- promoting recycling and disposal to mini- tion systems that, in conjunction with IT, will mize environmental impacts. To this end, gradually green the entire urban economy, green urbanization must strive after a mix with seismic network effects similar to those of entrepreneurship and specialized skills that arose from coal’s displacement of wood to research, produce, transport, install, as the primary source of energy. and service the technologies and products A green growth strategy can potentially driving green cities. Thus the productiv- reinforce the productivity gains from urban ity of green urbanization would be closely agglomeration by introducing technological related to technological change guided innovations and minimizing the productivity- by market and nonmarket signals, as eroding effects of urban sprawl, land use well as the quality and skills of the urban distortions, inattention to the design of workforce. 186 china 2 0 3 0 • Fully exploiting the sources of green instruments that support green urbaniza- growth will be a function of creative tion and how might they be improved. These urban and national bureaucracies commit- include: ted to a green agenda and able to respond quickly to new information, formulate • Public bureaucracies tasked with devis- and implement policies, and achieve the ing, implementing, and monitoring green necessary interdepartmental and inter- strategies jurisdictional coordination, the lack of • Local taxes, fees, and other charges to which all too often stifles change. More so manage energy and resource consump- than in the past, bureaucracies will need tion as well as to raise revenues, including to be prodded by a vigilant, informed, and some earmarked for green infrastructure networked civil society to set targets, learn and development. from best practice, and benchmark and • Use of local or national carbon markets to produce results. manage energy consumption • Zoning, land use, floor area ratios, real While the possibilities inherent in green estate and other property taxes (to limit technologies and green urbanization deserve urban sprawl), and urban design to arrest serious attention, good policies are difficult to current trends; promote compact, green identify and will emerge only after a number development; and begin transforming leg- of questions have been empirically addressed: acy urban infrastructure First, it is important to ascertain the • Subsidies, taxes, and other incentives in practicality of the green growth concept for support of specialized training to enlarge policy-making purposes and its compatibil- the pool of relevant skills, provide incen- ity with other views of economic growth. tives for research, and encourage start-up Moreover, given that the current share of activity in green industries green industries (producing “environmental • Standards and codes for structures and goods”) is small (accounting for about 1.5 equipment; eco-labeling; incentives to use percent of total employment in high-income green energy; and education programs to countries), what would it take for the green stimulate use of green technologies economy to become a significant growth • Fiscal instruments and financing vehicles driver within the next two decades? (public and private, foreign funded) to Second, it is desirable to canvas interna- raise the capital for the substantial up- tional experience with net job creation (are front spending needed to jump-start green green jobs new jobs?), local industrialization, development; implement green urban proj- and productivity gains at the city level, of ects, many with long payback periods; and policies aimed at increasing energy efficiency maintain the momentum of green develop- and conservation (smart meters); substituting ment over the long haul renewable energy for fossil-based energy, and • Technology parks, seed capital, and tax developing advanced energy storage devices exemptions to induce the formation of for use with intermittent power-generating green industrial clusters. sources; retrofitting existing residential and commercial structures and power, water sup- Finally, it is important to take a measure ply, transport, and sanitation systems with of green technologies likely to mature over new equipment based on green technology; the next 15 years, most of which are already and managing ownership and use of private known, and judge whether a new green gen- cars (with the help of sensor technologies eral purpose technology comparable to the and ICT). Internet and the internal combustion engine Third, China needs to learn from domes- is emerging, one that will transform many tic and international sources about the more areas of activity and result in long-term pro- effective application of policy vehicles and ductivity gains of the magnitude associated c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 187 with the diffusion of ICT. Such a measure constructed in two stages during 2011–30. would help clarify whether reasonably Government policy will provide most of the tested and cost-effective low-carbon, green impetus in the first stage, but success will technologies (in the construction industry, hinge on the quality of the workforce, the ini- for example, and related to the development tiative and strategy of firms, the emergence of smart transport systems) are already of supporting services, and the enabling accumulated and waiting to be exploited or environment provided by cities. Human tal- whether the technologies expected to have ent is the source of innovation: its flowering the largest payoffs (such as lightweight elec- depends on the research infrastructure in tric cars connected by a mobility Internet) firms and cities and the degree of global net - are still at an early stage of development or working. The innovativeness of the business as yet undiscovered. In other words, tomor- sector is a function of many factors, some of row’s green electrons should not just be which, such as management, competition, expensive versions of today’s brown elec- and strategy, are discussed here. trons: greening should be part and parcel With respect to China’s emerging inno- of a quantum leap in technology and pro- vative cities (coastal and inland), two points ductivity. The question to be asked is: How need to be emphasized. First, state-owned quickly could the most promising and rela- and state-controlled enterprises continue to tively cost-effective technologies be scaled account for a significant share of produc- up given financing availability, technological tion in key industries. Second, although the expertise, industrial capacity, public readi- innovation systems created by the cities are ness to adopt new technologies and life- encouraging new entrants, it is not apparent styles and constraints posed by legacy infra- from the low rate of entry and exit that truly structures, vested interests, and mainstream innovative firms, especially privately owned technologies? SMEs, are being groomed or that struggling firms are allowed to fail in sufficient num - bers. Making SOEs more innovative will Concluding Observations contribute significantly to China’s sustained Technological progress and the o fl urishing of growth. The best bet is an innovation system innovation in China will be the function of anchored to and drawing its energy from a a competitive, globally networked ecosystem competitive national economy. 188 china 2 0 3 0 Annex 2A Annex Tables TABle 2A.1 Annual TFP growth rate: Major industries, 1999–2004 Percent China Japan Korea, Rep. Construction −1.74 0.18 −1.06 Food and kindred −0.29 1.20 1.91 Products Textile mill products 0.16 1.56 1.65 Apparel 0.80 1.00 2.65 Paper and allied 1.47 0.57 1.57 Products Chemicals 0.60 1.94 −0.97 Stone, clay, and glass 3.70 2.09 3.48 Products Primary metals −0.28 1.53 −2.85 Nonelectrical 2.71 1.78 1.65 Machinery Electrical machinery 2.83 5.18 11.05 Motor vehicles 2.78 1.13 1.39 Transportation 4.94 1.80 9.15 Source: Ito and others 2008. TABle 2A.2 Top u SPTO patents by inventor resident in China, 2005–09 Percent Share of Class Rank Class title total patents 439 1 Electrical connectors 10.3 361 2 Electricity: electrical systems and devices 6.8 370 3 Multiplex communications 3.4 382 4 Image analysis 3.2 424 5 Drug, bio-affecting, and body treating compositions (includes class 514) 2.8 707 6 Dp: database and file management or data structures (data processing) 2.5 455 7 Telecommunications 2.1 438 8 Semiconductor device manufacturing: process 1.9 375 10 Pulse or digital communications 1.7 532 14 Organic compounds (includes classes 532-570) 1.4 435 17 Microbiology 1.1 385 Chemistry: molecular biology and optical waveguides 0.8 356 Optics: measuring and testing 0.6 280 Land vehicles 0.5 99 Foods and beverages: apparatus 0.2 123 Internal-combustion engines 0.2 180 Motor vehicles 0.1 Source: United States Patent and Trademark Office. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 189 TABle 2A.3 WiPO Patent Cooperation Treaty, share of international patents by sector, 2007–09 Percent Worldwide China Share of patents Sector of technology / field of technology Ratio Ratio held by China Total 100.00 100.00 3.15 I Electrical engineering 29.48 53.14 5.67 1 Electrical machinery, apparatus, energy 5.20 5.38 3.25 2 Audio-visual technology 3.16 2.46 2.45 3 Telecommunications 4.61 11.33 7.73 4 Digital communication 4.69 25.76 17.28 5 Basic communication processes 0.87 0.78 2.84 6 Computer technology 6.37 5.11 2.53 7 IT methods for management 1.27 0.70 1.72 8 Semiconductors 3.31 1.62 1.54 II Instruments 16.23 7.86 1.52 9 Optics 2.96 1.59 1.69 13 Medical technology 5.90 2.72 1.45 III Chemistry 29.61 18.49 1.97 15 Biotechnology 3.61 1.98 1.73 16 Pharmaceuticals 37.67 4.55 2.34 18 Food chemistry 1.11 0.72 2.04 19 Basic materials chemistry 3.42 1.68 1.54 20 Materials, metallurgy 2.00 1.37 2.16 21 Surface technology, coating 2.04 1.08 1.67 22 Micro-structural and nano-technology 0.25 0.04 0.45 23 Chemical engineering 2.76 2.08 2.38 24 Environmental technology 1.51 1.20 2.49 IV Mechanical engineering 18.31 12.93 2.22 32 Transport 3.46 2.21 2.01 Source: China State Intellectual Property Office. Note: Under the WIPO approach, one application may have several IPC classes and may belong to different technology fields. In this case, every technology field will be counted. As a result, the sum of the total number of all technology fields could be larger than the total number of applications in the year. 190 china 2 0 3 0 TABle 2A.4 Sector composition of new entrants (legal unit) by established time, Guangdong, Beijing, and Zhejiang, 2008 Percent Guangdong Beijing Zhejiang 1996–2000 2001–05 2006–08 1996–2000 2001–05 2006–08 1996–2000 2001–05 2006–08 Manufacturing 29.03 35.71 32.84 14.65 10.64 6.36 51.22 48.98 42.98 Processing of food from agricultural products 0.84 0.58 0.32 0.49 0.26 0.14 1.25 0.75 0.55 Manufacture of foods 0.86 0.59 0.34 0.53 0.29 0.19 0.50 0.33 0.27 Manufacture of beverage 0.29 0.24 0.15 0.20 0.11 0.05 0.65 0.46 0.31 Manufacture of tobacco 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Manufacture of textile 1.24 1.72 1.19 0.33 0.21 0.11 5.30 5.78 4.86 Manufacture of textile wearing apparel, footwear and caps 1.68 2.54 2.80 0.95 0.76 0.69 2.22 2.34 2.30 Manufacture of leather, fur, feather and its products 0.86 1.24 1.60 0.09 0.06 0.06 1.78 1.40 1.32 Processing of timbers, manufacture of wood, bamboo, rattan, palm, straw 0.46 0.54 0.61 0.20 0.22 0.24 0.75 0.78 0.82 Manufacture of furniture 0.97 1.02 1.16 0.46 0.44 0.42 0.55 0.58 0.63 Manufacture of paper and paper products 1.15 1.47 1.26 0.38 0.28 0.21 1.77 1.45 1.20 Printing, reproduction of recording media 1.52 1.67 1.00 0.62 0.41 0.21 1.85 1.56 0.89 Manufacture of articles for culture, education, and sport activity 0.62 0.67 0.55 0.17 0.11 0.05 1.01 1.04 0.88 Processing of petroleum, coking, processing of nucleus fuel 0.07 0.07 0.04 0.14 0.06 0.02 0.05 0.04 0.04 Manufacture of chemical raw material and chemical products 1.58 1.63 1.07 1.07 0.66 0.24 1.86 1.53 1.05 Manufacture of medicines 0.16 0.17 0.09 0.30 0.18 0.06 0.29 0.21 0.13 Manufacture of chemical fiber 0.04 0.06 0.02 0.02 0.01 0.01 0.21 0.23 0.14 Manufacture of rubber 0.33 0.45 0.43 0.10 0.06 0.03 0.69 0.58 0.44 Manufacture of plastic 2.56 3.21 2.89 0.75 0.48 0.25 3.72 3.74 3.26 Manufacture of nonmetallic mineral products 1.77 1.77 1.31 1.02 0.84 0.43 1.82 1.73 1.41 Manufacture and processing of ferrous metals 0.11 0.19 0.14 0.05 0.06 0.02 0.40 0.41 0.35 Manufacture and processing of nonferrous metals 0.26 0.40 0.33 0.11 0.09 0.03 0.52 0.50 0.40 Manufacture of metal products 3.22 3.87 3.75 1.40 1.13 0.63 3.59 3.39 3.09 Manufacture of general purpose machinery 1.15 1.57 1.51 1.28 0.90 0.56 6.46 6.64 6.00 Manufacture of special purpose machinery 1.09 1.64 1.87 1.05 0.80 0.43 2.30 2.41 2.18 Manufacture of transport equipment 0.70 0.80 0.56 0.51 0.43 0.20 2.87 2.65 2.73 Manufacture of electrical machinery and equipment 2.34 3.08 3.10 0.87 0.64 0.41 4.43 4.07 3.79 Manufacture of communication, computer, other electronic equipment 1.77 2.73 2.96 0.70 0.52 0.25 1.18 1.22 1.11 Manufacture of measuring instrument, machinery for cultural and office work 0.40 0.46 0.49 0.58 0.43 0.21 1.23 0.87 0.66 Manufacture of artwork, other manufacture 0.87 1.14 1.05 0.28 0.20 0.20 1.84 2.09 2.01 Information transfer, computer services, and software 1.41 2.78 3.52 4.86 6.80 6.69 1.11 2.40 3.15 Telecommunications and other information transmission services 0.25 0.43 0.55 0.74 1.05 0.92 0.18 0.20 0.21 Computer services 0.45 1.16 1.57 1.78 2.23 2.23 0.56 1.60 1.98 Software 0.70 1.18 1.40 2.34 3.52 3.55 0.37 0.61 0.96 Finance 0.23 0.29 0.37 0.24 0.40 0.47 0.18 0.30 0.59 Banking 0.08 0.01 0.05 0.05 0.01 0.04 0.05 0.03 0.03 Securities 0.04 0.02 0.01 0.05 0.04 0.05 0.01 0.00 0.02 Insurances 0.05 0.18 0.18 0.06 0.21 0.18 0.04 0.09 0.14 Other financial activities 0.06 0.08 0.13 0.09 0.14 0.20 0.08 0.17 0.40 Tenancy and business services 9.04 9.01 9.93 12.77 17.38 20.13 6.45 6.12 8.68 Leasing 0.10 0.17 0.20 0.71 0.68 0.72 0.16 0.20 0.38 Business services 8.95 8.84 9.73 12.05 16.71 19.41 6.30 5.91 8.30 Scientific research, technical service, and geologic perambulation 1.98 2.87 3.16 6.68 7.53 8.69 1.74 2.21 2.63 Scientific research and experiment development 0.30 0.63 0.92 0.63 0.79 0.75 0.17 0.18 0.22 Technical service 1.35 1.78 1.75 2.67 2.93 2.74 1.05 1.30 1.23 Scientific exchange and disseminate service 0.32 0.45 0.48 3.32 3.72 5.12 0.50 0.72 1.17 Geologic perambulation 0.01 0.01 0.01 0.05 0.08 0.06 0.01 0.01 0.01 Education 3.97 2.42 1.56 1.89 1.85 1.66 3.24 2.04 1.31 Source: Economic Census Yearbook, Beijing, Guangdong, and Zhejiang 2008. Note: The table shows the share of newly entering firms in each category for the stated period. For example, 29.03 percent of the aggregate newly entering firms established in 1996–2000 in Guangdong province were manufacturing firms. New entrants are only those surviving in the survey year; firms that closed before the survey year were not counted. The data reflect the time a firm was established and do not reflect a possible move from one industrial sector to another. The new entry of S&T firms might thus be underestimated if a large proportion of them changed their industry affiliation from traditional sectors to high-tech sectors c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 191 TABle 2A.4 Sector composition of new entrants (legal unit) by established time, Guangdong, Beijing, and Zhejiang, 2008 Percent Guangdong Beijing Zhejiang 1996–2000 2001–05 2006–08 1996–2000 2001–05 2006–08 1996–2000 2001–05 2006–08 Manufacturing 29.03 35.71 32.84 14.65 10.64 6.36 51.22 48.98 42.98 Processing of food from agricultural products 0.84 0.58 0.32 0.49 0.26 0.14 1.25 0.75 0.55 Manufacture of foods 0.86 0.59 0.34 0.53 0.29 0.19 0.50 0.33 0.27 Manufacture of beverage 0.29 0.24 0.15 0.20 0.11 0.05 0.65 0.46 0.31 Manufacture of tobacco 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Manufacture of textile 1.24 1.72 1.19 0.33 0.21 0.11 5.30 5.78 4.86 Manufacture of textile wearing apparel, footwear and caps 1.68 2.54 2.80 0.95 0.76 0.69 2.22 2.34 2.30 Manufacture of leather, fur, feather and its products 0.86 1.24 1.60 0.09 0.06 0.06 1.78 1.40 1.32 Processing of timbers, manufacture of wood, bamboo, rattan, palm, straw 0.46 0.54 0.61 0.20 0.22 0.24 0.75 0.78 0.82 Manufacture of furniture 0.97 1.02 1.16 0.46 0.44 0.42 0.55 0.58 0.63 Manufacture of paper and paper products 1.15 1.47 1.26 0.38 0.28 0.21 1.77 1.45 1.20 Printing, reproduction of recording media 1.52 1.67 1.00 0.62 0.41 0.21 1.85 1.56 0.89 Manufacture of articles for culture, education, and sport activity 0.62 0.67 0.55 0.17 0.11 0.05 1.01 1.04 0.88 Processing of petroleum, coking, processing of nucleus fuel 0.07 0.07 0.04 0.14 0.06 0.02 0.05 0.04 0.04 Manufacture of chemical raw material and chemical products 1.58 1.63 1.07 1.07 0.66 0.24 1.86 1.53 1.05 Manufacture of medicines 0.16 0.17 0.09 0.30 0.18 0.06 0.29 0.21 0.13 Manufacture of chemical fiber 0.04 0.06 0.02 0.02 0.01 0.01 0.21 0.23 0.14 Manufacture of rubber 0.33 0.45 0.43 0.10 0.06 0.03 0.69 0.58 0.44 Manufacture of plastic 2.56 3.21 2.89 0.75 0.48 0.25 3.72 3.74 3.26 Manufacture of nonmetallic mineral products 1.77 1.77 1.31 1.02 0.84 0.43 1.82 1.73 1.41 Manufacture and processing of ferrous metals 0.11 0.19 0.14 0.05 0.06 0.02 0.40 0.41 0.35 Manufacture and processing of nonferrous metals 0.26 0.40 0.33 0.11 0.09 0.03 0.52 0.50 0.40 Manufacture of metal products 3.22 3.87 3.75 1.40 1.13 0.63 3.59 3.39 3.09 Manufacture of general purpose machinery 1.15 1.57 1.51 1.28 0.90 0.56 6.46 6.64 6.00 Manufacture of special purpose machinery 1.09 1.64 1.87 1.05 0.80 0.43 2.30 2.41 2.18 Manufacture of transport equipment 0.70 0.80 0.56 0.51 0.43 0.20 2.87 2.65 2.73 Manufacture of electrical machinery and equipment 2.34 3.08 3.10 0.87 0.64 0.41 4.43 4.07 3.79 Manufacture of communication, computer, other electronic equipment 1.77 2.73 2.96 0.70 0.52 0.25 1.18 1.22 1.11 Manufacture of measuring instrument, machinery for cultural and office work 0.40 0.46 0.49 0.58 0.43 0.21 1.23 0.87 0.66 Manufacture of artwork, other manufacture 0.87 1.14 1.05 0.28 0.20 0.20 1.84 2.09 2.01 Information transfer, computer services, and software 1.41 2.78 3.52 4.86 6.80 6.69 1.11 2.40 3.15 Telecommunications and other information transmission services 0.25 0.43 0.55 0.74 1.05 0.92 0.18 0.20 0.21 Computer services 0.45 1.16 1.57 1.78 2.23 2.23 0.56 1.60 1.98 Software 0.70 1.18 1.40 2.34 3.52 3.55 0.37 0.61 0.96 Finance 0.23 0.29 0.37 0.24 0.40 0.47 0.18 0.30 0.59 Banking 0.08 0.01 0.05 0.05 0.01 0.04 0.05 0.03 0.03 Securities 0.04 0.02 0.01 0.05 0.04 0.05 0.01 0.00 0.02 Insurances 0.05 0.18 0.18 0.06 0.21 0.18 0.04 0.09 0.14 Other financial activities 0.06 0.08 0.13 0.09 0.14 0.20 0.08 0.17 0.40 Tenancy and business services 9.04 9.01 9.93 12.77 17.38 20.13 6.45 6.12 8.68 Leasing 0.10 0.17 0.20 0.71 0.68 0.72 0.16 0.20 0.38 Business services 8.95 8.84 9.73 12.05 16.71 19.41 6.30 5.91 8.30 Scientific research, technical service, and geologic perambulation 1.98 2.87 3.16 6.68 7.53 8.69 1.74 2.21 2.63 Scientific research and experiment development 0.30 0.63 0.92 0.63 0.79 0.75 0.17 0.18 0.22 Technical service 1.35 1.78 1.75 2.67 2.93 2.74 1.05 1.30 1.23 Scientific exchange and disseminate service 0.32 0.45 0.48 3.32 3.72 5.12 0.50 0.72 1.17 Geologic perambulation 0.01 0.01 0.01 0.05 0.08 0.06 0.01 0.01 0.01 Education 3.97 2.42 1.56 1.89 1.85 1.66 3.24 2.04 1.31 Source: Economic Census Yearbook, Beijing, Guangdong, and Zhejiang 2008. Note: The table shows the share of newly entering firms in each category for the stated period. For example, 29.03 percent of the aggregate newly entering firms established in 1996–2000 in Guangdong province were manufacturing firms. New entrants are only those surviving in the survey year; firms that closed before the survey year were not counted. The data reflect the time a firm was established and do not reflect a possible move from one industrial sector to another. The new entry of S&T firms might thus be underestimated if a large proportion of them changed their industry affiliation from traditional sectors to high-tech sectors 192 china 2 0 3 0 TABle 2A.5 Number of patents in force in the high-tech industry, by industrial sector and registration status, 2009 Large Medium Small enterprises Share (%) enterprises Share (%) enterprises Share (%) Total 22,975 55.81 8,855 21.51 9,340 22.69 Manufacture of medicines 1,460 24.26 2,451 40.73 2,106 35.00 Manufacture of chemical medicine 795 32.41 967 39.42 691 28.17 Manufacture of finished traditional Chinese herbal medicine 646 29.16 1,031 46.55 538 24.29 Manufacture of biological and biochemical chemical products 10 1.32 284 37.47 464 61.21 Manufacture of aircrafts and spacecrafts 368 59.16 197 31.67 57 9.16 Manufacture and repairing of airplanes 367 69.11 113 21.28 51 9.60 Manufacture of spacecrafts 1 1.52 59 89.39 6 9.09 Manufacture of electronic equipment and communication equipment 17,120 69.70 4,178 17.01 3,264 13.29 Manufacture of communication equipment 14,000 89.68 770 4.93 841 5.39 Manufacture of radar and its fittings 12 24.49 31 63.27 6 12.24 Manufacture of broadcasting and T V equipment 83 27.04 66 21.50 158 51.47 Manufacture of electronic appliances 2,084 43.98 1,523 32.14 1,131 23.87 Manufacture of electronic components 328 18.50 848 47.83 597 33.67 Manufacture of domestic T V set and radio receiver 553 41.02 612 45.40 183 13.58 Manufacture of other electronic equipment 60 8.15 328 44.57 348 47.28 Manufacture of computers and office equipment 3,525 70.28 667 13.30 824 16.43 Manufacture of entire computer 2,630 94.47 108 3.88 46 1.65 Manufacture of computer peripheral equipment 437 27.96 444 28.41 682 43.63 Manufacture of office equipment 1 1.25 41 51.25 38 47.50 Manufacture of medical equipment and measuring instrument 502 10.14 1,362 27.50 3,089 62.37 Manufacture of medical equipment and appliances 112 7.85 322 22.58 992 69.57 Manufacture of measuring instrument 390 11.06 1,040 29.49 2,097 59.46 Source: China Statistics Yearbook on High Technology Industry 2010. TABle 2A.6 innovation inputs and outputs of industrial enterprises in China, by enterprise size, 2009 Percent R&D spending R&D personnel Share of patents in force Share of patents Share with as share of core as share of per RMB 100 million of in force per Size of enterprise R&D activities business sales revenue total employment R&D expenditure 100 R&D personnel Total 8.47 0.74 2.19 29.18 6.18 Large and medium 30.48 1.03 3.19 23.58 5.37 Small 6.16 0.28 0.99 61.90 9.27 Source: China Statistical Yearbook on Science and Technology 2010. TABle 2A.7 innovation inputs and outputs of industrial enterprises in the high-tech industry in China, by enterprise size, 2009 Percent R&D spending Share of patents Share of Share of as share of R&D personnel in force per RMB patents in force enterprises with Share with core business as share of total 100 million of per 100 Size of enterprise R&D institutions R&D activities sales revenue employment R&D expenditure R&D personnel Total 17.52 25.53 1.63 4.96 42.51 8.67 Large-sized enterprises 53.61 61.68 1.71 6.06 43.67 10.81 Medium-sized enterprises 40.82 46.81 1.81 4.87 28.01 5.22 Small-sized enterprises 12.01 20.42 1.12 3.58 74.03 10.11 Source: China Statistical Yearbook on Science and Technology 2010. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 193 TABle 2A.8 Foreign direct investment: capital utilized by industry, 2004–09 Industry 2004 2007 2009 Total 100 100 100 Agricultural 1.84 1.11 1.52 Agricultural: farming 0.89 0.47 0.80 Mining 0.89 0.59 0.53 Manufacturing 70.95 48.93 49.72 Textile 3.88 2.21 1.48 Chemical material and product 4.38 3.46 4.24 Medical and pharmaceutical product 1.11 0.72 1.00 Universal machinery 3.58 2.58 3.17 Special purpose equipment 3.13 2.77 2.74 Communications, computer, and other electronic equipment 11.64 9.20 7.63 Electricity, gas, and water production and supply 1.87 1.28 2.25 Construction 1.27 0.52 0.74 Transport, storage and postal service 2.10 2.40 2.69 Information transmission, computer service and software 1.51 1.78 2.39 Wholesale and retail trade 1.22 3.20 5.73 Accommodation and catering trade 1.39 1.25 0.90 Banking and insurance 0.42 10.79 4.77 Real estate 9.81 20.46 17.86 Leasing and commercial service 4.66 4.81 6.46 Scientific research, polytechnic service, and geological 0.48 1.10 1.78 Water conservancy, environment, and public utility mgt 0.38 0.33 0.59 Residential and other service 0.26 0.87 1.69 Education 0.06 0.04 0.01 Health care, social security and welfare 0.14 0.01 0.05 Culture, sport, and recreation 0.74 0.54 0.34 Public management and social organization 0.00 0.00 0.00 Source: CEIC database. TABle 2A.9 Patent family applications by value and country absolute volume High value Intermediate value Low value Year China Germany United States China Germany United States China Germany United States 1990 5 2,139 5,784 51 10,101 40,232 27,343 32,021 40,232 1991 5 1,781 4,747 37 10,445 39,887 33,158 35,216 39,887 1992 7 1,727 4,696 59 10,614 42,843 43,215 38,082 42,843 1993 4 1,868 4,314 47 11,014 48,298 44,879 40,573 48,298 1994 5 2,056 4,200 69 11,766 55,841 42,237 42,400 55,841 1995 3 2,107 3,888 64 12,073 62,261 41,296 43,300 62,261 1996 4 2,100 3,980 74 14,003 61,888 46,287 47,106 61,888 1997 8 1,851 3,977 97 15,218 68,525 48,099 49,319 68,525 1998 6 1,836 3,799 121 16,349 65,965 50,476 51,057 65,965 1999 5 1,543 3,743 160 17,167 66,363 59,659 52,417 66,363 2000 2 1,421 3,312 269 16,807 65,797 74,843 51,879 65,797 2001 10 980 2,564 333 16,143 62,624 87,826 49,961 62,624 2002 15 644 2,361 461 14,896 59,977 109,524 46,721 59,977 2003 13 556 2,027 759 15,603 50,830 133,444 47,140 50,830 2004 27 629 2,142 1,347 17,345 49,273 147,734 50,054 49,273 2005 25 606 1,722 2,528 18,321 50,098 187,067 47,245 50,098 Sum 141 23,843 57,254 6,476 227,867 890,706 1,177,087 724,491 890,706 Source: Boeing and Sandner 2011. 194 china 2 0 3 0 TABle 2A.10 r egional and provincial productivity in China RMB 10,000/person 2004 2005 2007 2009 Eastern Region 3.625 4.137 5.359 6.518 Beijing 6.771 7.482 8.416 9.683 Fujian 3.171 3.516 4.627 5.642 Guangdong 4.371 4.757 5.873 6.996 Guangxi 1.296 1.508 2.158 6.996 Hainan 2.180 2.368 2.949 2.711 Hebei 2.481 2.912 3.843 3.834 Jiangsu 4.034 4.721 6.139 4.420 Liaoning 3.419 4.048 5.322 7.596 Shandong 3.041 3.623 4.934 6.946 Shanghai 9.938 10.696 13.905 6.220 Tianjin 7.373 8.662 11.671 16.192 Zhejiang 3.767 4.196 5.195 14.828 Central Region 1.890 2.201 3.004 3.937 Anhui 1.378 1.543 2.047 2.727 Heilongjiang 2.926 3.390 4.256 5.089 Henan 1.531 1.870 2.601 3.275 Hubei 2.176 2.436 3.341 4.285 Hunan 1.567 1.780 2.454 3.342 Inner Mongolia 2.984 3.742 5.632 8.526 Jiangxi 1.695 1.925 2.505 3.411 Jilin 2.799 3.293 4.821 6.144 Shanxi 2.422 2.831 3.699 4.600 Western Region 1.436 1.625 2.199 2.939 Chongqing 1.594 1.784 2.304 3.476 Gansu 1.277 1.435 1.966 2.408 Guizhou 0.774 0.893 1.201 1.671 Ningxia 1.802 2.023 2.873 4.120 Qinghai 1.772 2.030 2.836 3.787 Shaanxi 1.685 1.952 2.844 4.256 Sichuan 1.417 1.604 2.198 2.862 Tibet 1.634 1.789 2.227 2.610 Xinjiang 2.967 3.407 4.399 5.158 Yunnan 1.283 1.411 1.823 2.260 Source: China Statistical Yearbook 2005–2010. Note: Productivity is calculated by dividing regional GDP by region’s labor force. TABle 2A.11 Domestic patents granted in different provinces in China, 2009 Eastern Region Central Region Western Region Beijing 22,921 Anhui 8,594 Chongqing 7,501 Fujian 11,282 Heilongjiang 5,079 Gansu 1,274 Guangdong 83,621 Henan 11,425 Guizhou 2,084 Guangxi 2,702 Hubei 11,357 Ningxia 910 Hainan 630 Hunan 8,309 Qinghai 368 Hebei 6,839 1,494 Shaanxi 6,087 Jiangsu 87,286 Inner Mongolia 2,915 Sichuan 20,132 Liaoning 12,198 Jiangxi 3,275 Tibet 292 Shandong 34,513 Jilin 3,227 Xinjiang 1,866 Shanghai 34,913 Shanxi Yunnan 2,923 Tianjin 7,404 Zhejiang 79,945 Source: China Statistical Yearbook on Science and Technology 2010. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 195 TABle 2A.12 innovation inputs and outputs of industrial enterprises in China, 2009 Percentage R&D spending Share of patents Share of Share of as share of R&D personnel in force per RMB patents in force enterprises with Share with core business as share of total 100 million of per 100 Enterprises R&D institutions R&D activities sales revenue employment R&D expenditure R&D personnel Total 5.91 8.47 0.74 2.19 29.18 6.18 State-owned enterprises 10.61 14.12 0.69 2.63 17.92 3.71 Large SOEs 56.56 50.86 0.85 3.48 14.10 3.27 Private enterprises 6.38 4.07 0.39 1.22 43.42 7.44 Enterprises with funds from Hong Kong SAR, China; Macao SAR, China; and Taiwan, China 10.41 7.71 0.76 1.76 28.81 5.62 Foreign-funded enterprises 8.22 11.62 0.69 2.18 26.17 6.32 Source: China Statistical Yearbook on Science and Technology 2010. TABle 2A.13 Distribution of innovation inputs in China, by type of performer, 2009 Number of Number of R&D personnel Expenditure on patents in force enterprises (unit) Share (%) (thousands) Share (%) R&D (billions) Share (%) (piece) Share (%) Total 429,378 100.0 1,914.27 100.0 405.20 100.0 11,8245 100.0 State-owned enterprises 8,860 2.06 174.77 9.13 36.16 8.92 6,478 5.48 Large-size SOEs 419 0.10 119.64 6.25 27.75 6.85 3,913 3.31 Private enterprises 253,366 59.01 356.35 18.62 61.09 15.08 26,528 22.43 Enterprises with funds from Hong Kong SAR, China; Macao SAR, China; and Taiwan, China 33,865 7.89 198.82 10.39 38.80 9.58 11,179 9.45 Foreign-funded enterprises 40,502 9.43 284.39 14.86 68.65 16.94 17,965 15.19 Source: China Statistical Yearbook on Science and Technology 2010. 196 china 2 0 3 0 TABle 2A.14 Distribution of innovation inputs and outputs in high-tech industry in China, by type of performer, 2009 Number of Number of R&D personnel Expenditure on patents in force enterprises (unit) Share (%) (thousands) Share (%) R&D (billions) Share (%) (piece) Share (%) Total 27,218 100.0 474.63 100.0 96.84 100.0 41,170 100.0 Domestic 17,922 65.85 297.83 62.75 60.69 62.67 29,254 71.06 State-owned enterprises 469 1.72 26.32 5.54 5.37 5.54 1,178 2.86 Enterprises with funds from Hong Kong SAR, China; Macao SAR, China; and Taiwan, China 3,809 13.99 70.39 14.83 13.37 13.81 4,713 11.45 Foreign-funded enterprises 5,487 20.16 106.41 22.42 22.79 23.53 7,203 17.50 Source: China Statistics Yearbook on High Technology Industry 2010. TABle 2A.15 innovation inputs and outputs of industrial enterprises in high-tech industry in China, 2009 Percent R&D spending Share of patents Share of Share of as share of R&D personnel in force per RMB patents in force enterprises with Share with core business as share of total 100 million of per 100 Enterprises R&D institutions R&D activities sales revenue employment R&D expenditure R&D personnel Total 17.52 25.53 1.63 4.96 42.51 8.67 Domestic 18.32 27.11 2.97 7.32 48.21 9.82 State-owned enterprises 27.93 41.36 3.81 8.70 21.95 4.48 Enterprises with funds from Hong Kong SAR, China; Macao SAR, China; and Taiwan, China 16.30 22.92 1.13 3.29 35.25 6.70 Foreign-funded enterprises 15.73 22.18 0.83 3.16 31.61 6.77 Source: China Statistics Yearbook on High Technology Industry 2010. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 197 TABle 2A.16 r oles of various entities involved in Nation innovation System The actions that the Institutions and policies that could Entities in NIS Primary objectives Incentive mechanisms entities should and could take influence the behaviors of the entities Domestic Sustained Market competition Improve management; Purchase Promote effective competition; enterprises profitability; as driving force of technology; Long-term R&D Protection of IPR; Enhance the supply Long-term for innovation investment; Research networking; of human resources; Encourage competitiveness (Schumpeter ian Recruit talents entrepreneurship Tax incentives innovation) for R&D investment; Demands-side incentives; Foreign Sustained Market competition Purchase technology from the Promote a fully completive funded profitability; as driving force parent company; Launch local R&D environment; Credible IPR protection; enterprises Long-term for innovation activities; Hire local talents Enhance the supply of human competitiveness (Schumpeter resources; Incentives for establishing innovation) R&D facilities and investing in R&D Universities Cultivate talents; Teaching evaluation; Reform education philosophy; Grant more autonomy to universities; Frontier research Funds granted improve education methods; Recruit Reform the evaluation and appraisal from the state; top-grade faculties; Encourage free system of university; Reform the grant Peer pressure thinking and independent research award and evaluation system of major R&D projects R&D Applied and Funds granted Design effective internal incentive Reform grant award system for major institutions basic research; from the state; mechanisms; Recruit first grade R&D projects; Increase funds for hiring Cultivate talents Peer pressure scientists and engineers experts and postdoctoral fellows Engineers and Wealth creation; Professional Self-motivated lifelong learning; Reform grant award system for major scientists Seeking after truth discipline; Perseverance R&D projects; Encourage freedom in Peer pressure research; Reform the appraisal and compensation system Industry Serve companies Trust of the firms; Promote the cooperation between Grant more autonomy to industry associations Recognition by the firms; Improve communications associations society between governments and industry; Facilitate R&D alliances Financial Profit maximization; High profits; market Professional investment team; Good Create good financial eco-system; institutions Long-term competition; Comply risk management mechanisms Keep balance market competition and competitiveness with the laws and regulation; Provide tax deduction for regulations the capital invested in the high-tech enterprises Central Economic and Demand and needs Improve the infrastructure, especially Reform of the administrative government social development; of the people; Global those related to ICT, to facilitate the management system; Create a rule- National security competitive pressure transmission and flow of knowledge; of-law government; Responsive to the Develop effective market; Strengthen people’s demand the social security system; Increase investment in education and enhance the quality of education; Improve national innovation system; Sustained investment in basic research; Promote R&D by firms; Organize major R&D projects; Create initial demands through the first-buyer strategy of government procurement Local Sustainable regional Performance Improve infrastructure and Reform appraisal system for local government economic and social appraisal by superior; institutions to create an enabling government officials; Promote development Competition environment for business start-ups regional competition in a unified between regions; and innovation; Promote R&D by national market; Responsive to the Demand and needs firms; Promote the development of people’s demand of local citizens local industrial clusters Source: Authors. 198 china 2 0 3 0 products, markets, sources of materials, new Notes production processes, and new organiza- 1. As ranked by the Times Higher Educa- tional forms. To these, one can add design tion Supplement 2011. The list includes and marketing and the list can go on. Dodg- universities in Hong Kong SAR, son and Gann (2010, 11), in their portrait China. http://www.topuniversities.com of Josiah Wedgewood, the renowned serial / w o r l d - u n ive r s it y - r a n k i n g s / q s - w o r l d innovator, maintain that the enduring truth -university-rankings-2011. about innovation is that it “involves new 2. This projection is found in China’s Science combinations of ideas, knowledge, skills and Technology Medium-to-Long Term and resources. [Wedgewood] was a master Plan. For more discussion and analysis, see at combining the dramatic scientific, techno - Lu (2006); Xu (2006); Zhang, Liu, and Lu logical and artistic advances of his age with (2008); and Lu (2009). An earlier book rapidly changing consumer demand. The by Sigurdson and others (2005) visualizes way in which [Wedgewood] merged tech- China as an emerging “technological super- nological and market opportunities, art and power.” See also Hu (2011, 95), who believes manufacturing, creativity and commerce, is that by 2020, China will be an innovative perhaps, his most profound lesson for us.” country and the largest knowledge-based According to a recent survey by Hall (2011), society in the world. product innovation was unambiguously 3. These are the findings of the Development more productive than process innovation. In Research Center’s study on growth pros- services, marketing, customer relations, and pects. More than 320 million workers the clever use of IT can be decisive. continue to derive their livelihoods from 6. Jones and Romer (2009) explain the large agriculture, and this number will shrink differences in per capita GDP among coun- as agricultural productivity grows. Thus tries with reference to both factor inputs and the transfer of workers from agriculture to the residual. However, they note that “dif- more productive services will continue to ferences in income and TFP across countries yield a productivity bonus for some time. are large and highly correlated: poor coun- However, once this transfer is largely com- tries are poor not only because they have less pleted, the increasing absorption of workers physical and human capital per worker than in nontradable services that historically have rich countries, but also because they use registered very small or negative increases their inputs much less efficiently.” in productivity, could slow future gains in 7. Lester (2004, p. 5) observes that the real productivity. Two recent papers question wellsprings of creativity in the U.S. econ- whether China is close to this so-called omy are the “capacity to integrate across “Lewis turning point.” Knight, Deng, and organizational, intellectual and cultural Li (2011, 597) maintain that “there is a sub- boundaries, the capacity to experiment, and stantial supply of migrants still available in the habits of thought that allow us to make rural China. . . . Rural workers will have sense of radically ambiguous situations and better opportunities to migrate for employ- to move forward in the face of uncertainty.” ment and older workers will have a stron- 8. This count excludes Singapore and Hong ger incentive to move with their families as Kong SAR, China, which also achieved central and local governments respond to high-income status but, because of their the economic need for a more settled urban small size, can shed very limited light on workforce.” This view is echoed by Golley policies for China. and Meng (2011, 571): “There is an abun- 9. Japan differs from the other two because dance of rural workers who appeared to be it was already an industrial power before under-employed with earnings well below World War II capable of fielding weaponry their migrant counterparts.” comparable to that of the Western nations. 4. Comin, Hobijn, and Rovito (2006) ascribe For comparative purposes, however, the Jap- the bulk of productivity differentials among anese experience remains relevant. countries to lags in the assimilation of 10. The Toyota Motor Company was among technologies. the pacesetters that borrowed techniques 5. In its original form as proposed by Joseph and ideas pioneered in the United States and Schumpeter, innovation embraced new adapted them to Japanese conditions. The c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 199 story of how entrepreneurs and inventors and useless concept for policy making.” The transformed the Japanese electronics indus- sources of growth in China are estimated try is well told by Johnstone (1999). Japan’s by, among others, Wang and Yao (2003); technology development and innovativeness Badunenko, Henderson, and Zelenyuk is the subject of two excellent volumes writ- (2008); and Urel and Zebregs (2009), all of ten by Odagiri and Goto (1996, 1997). whom find that capital played the leading 11. The keiretsu in Japan, and the chaebol in role. Time series analysis arrives at similar Korea. results. Chen, Jefferson, and Zhang (2011) 12. Among the innovations introduced by survey the sources of growth literature on Korean companies was the 256 MB DRAM China. (by Samsung in 1998). The dedicated sili- 16. See also the estimates on sources of growth con merchant foundry pioneered by Morris and China’s share of the world economy in Chang at TSMC in 1987 was a fundamental OECD (2010b). innovation, which built on the creation of 17. Chen, Jefferson, and Zhang (2011) ascribe standardized circuit design rules and elec- the slowdown in TFP growth since 2001 to tronic design automation to transform the industrial policies that have reduced alloca- chip manufacturing industry. This innova- tive efficiency, factor market distortions that tion greatly widened the options for chip divert financial resources to less produc- designers, who had hitherto depended on tive uses, and the diminishing productivity excess capacity at vertically integrated chip bonus from structural change. manufacturers such as Texas Instruments 18. Yu (2009). Perkins (2011) estimates that to produce their chips (Perry 2011). See China’s capital to output ratio rose from Mathews and Cho (2000); Breznitz (2007); 3.79 in the 1990s to 4.25 in 2000 – 07 and to Hsueh, Hsu, and Perkins (2001, specifi- 4.89 in 2008–09. With a ratio of investment cally the annex by Ying-yi Tu); and Brown to GDP approaching 50 percent in 2011, and Linden (2009) on the technological China is now investing far more than Japan development of Korea and Taiwan, China. did at the height of its boom and deriving a On fabless firms and production, see http:// roughly equivalent amount of growth. microlab.berkeley.edu/text/seminars/slides 19. Even at its peak, TFP growth was generally /RChen.pdf; http://cadlab.cs.ucla.edu/icsoc less than 3 percent for almost all countries. /pr o t e c t e d - d i r / I C - DF N _ A g e n d a _ Au g For example, even during its years of rapid _ 20 0 7/ J e r e my%20Wa n g - F S A%20 I ndu growth, Finland averaged 2.8 percent a year. -stry%20Update.pdf. 20. The estimates differ. Those given here are 13. Breznitz and Murphree (2011) argue that from the OECD. See Groupe BPCE (2010); China does not need to master break- Fukao and others (2008); and OECD Sta- throughs over the near term to achieve eco- tistics Portal, http://stats.oecd.org/Index nomic success. Instead, it can be a successful .aspx?DatasetCode=MFP. second-generation innovator since the spec- 21. Eichengreen (2012) observes that the annual trum of innovation possibilities is so wide. growth of productivity in China’s services On innovation and China’s sustainable sector barely exceeds 1 percent, compared development, see Fang (2007) and Gao and with 8 percent in industry, and that the sec- Liu (2007). tor conducts little R&D. He calls for a revo- 14. Translating promising discoveries into prof- lution in services for China to catch up with itable innovations can take many years if not the United States. decades. The high-strength synthetic fiber 22. Comin (2004). Kevlar created by DuPont took 17 years to 23. As noted earlier, China’s exports of manu- achieve commercial viability, and it is not an factures overlap with those of the United exception. States, but wide differences in quality and 15. The estimates by Bosworth and Collins are technological sophistication remain. among the higher ones. Total factor pro- 24. The Fukushima disaster has further ductivity is one of the most widely used sensitized companies to supply chain indicators of growth, but its worth for vulnerabilities. policy-making purposes is uncertain. Felipe 25. An aspect of learning highlighted by Lev- (2008), for instance, is outspokenly critical, itt, List, and Syverson (2011) and critical claiming that “TFP a dubious, misleading to the profitability of electronic component 200 china 2 0 3 0 manufacturing, for example, but also to that University Press (http://www.nri.org.uk of autos, is a reduction in the number of / science.html). See also Subramanian (2011) defects, which is a function of worker skills on why China is well placed to regain its ear- and familiarity with the production process lier preeminence. Subramanian computes a and of the plant’s physical and organiza- dominance index based on a country’s GDP, tional capital. trade, and status as a creditor. He is of the 26. According to Felipe, Abdon, and Kumar view, that as of 2010, China might already (2010), as early as the 1960s, China was have pulled ahead of the United States and exporting 105 commodities (with compara- could be well in the forefront by 2030. And tive advantage) from the 779 commodities in this dominance could very likely extend to their sample, many more than either Korea the technological domain. or Brazil. By 2006, the number had risen to 31. Walsh (2003). Zhang and Long (2011) pro- 269, well ahead of Japan (192). Of these, vide detailed analysis on investment by mul- 100 products were from the core of the tinational corporations in R&D activities in product space. China continues to export, China. with comparative advantage, 69 labor- 32. See Gao, Zhang, and Liu (2007) on the intensive products; its exports of machinery efforts of Dawning and HiSense to cap man- have risen from 1 in 1962 to 57; it has lost ufacturing capability with own innovation. comparative advantage in less sophisticated 33. The companies listed in the Forbes Global metal products and gained it in products 2000 generate $30 trillion in annual rev- with higher PRODY, which is the average enue, equal to one-half the global GDP. income of a country associated with that China still has only limited representation good. China has also forged ahead with in this group—with less than 5 percent of telecommunication and electronic products the revenue. The Chinese firms making and office equipment. As a consequence, the headway in the sphere of manufacturing are unweighted PRODY of China’s core exports Haier, Lenovo, BYD, Huawei, and ZTE. rose from $14,741 in 1962 to $16,307 in Lenovo’s experience with the acquisition of 1980 to $17,135 in 2006. IBM’s personal computer business and that 27. Data collected by Thomson Reuters shows of TCL with the takeover of Thomson’s TV that China’s patent rankings by subsector arm suggest that the acquisition of large for- are highest for chemical engineering, where eign firms with brand names can bolster the it is second after the United States. The fortunes of ambitious Chinese companies if rankings are fourth or lower for other major they can muster the managerial expertise subsectors (Zhou and Stembridge 2011). to harness and grow the reputational capi- 28. The data generated by the Nature Publish- tal of the acquired foreign assets and cope ing Group (2010) indicate that Chinese with the challenges posed by transnational researchers are increasing their contribution operations. On Lenovo’s circumstances, see to genetics, clinical medicine, and structural “Short of Soft Skills: Lenovo’s Bid to Become biology. a Global Brand Is Coming Unstuck,” Busi- 29. As of 2012, Huawei had emerged as the ness China, June 8, 2009. The acquisition world’s largest supplier of telecom equip- of Volvo, the Swedish carmaker, by Geely, ment (in 2011, its revenues amounted to the privately owned, Hangzhou-based Chi- $32 billion), although Ericsson remains the nese manufacturer, will be another impor- leading producer of network infrastructure tant test case of whether a Chinese firm equipment; see “Huawei: The Company can turn around an ailing foreign company That Spooked the World,” E conomi st , and effectively sustain and capitalize on its August 4, 2012, pp. 19–23. See also Nolan reputation. (2012), who compares the relative (global) 34. See Price and others (2011) on the success standing of Chinese and other leading multi- of China’s efforts to reduce the energy inten- national corporations. sity of the economy by 20 percent during the 30. This leadership has been convincingly docu- course of the 11th Five Year Plan. mented by the series of volumes on China’s 35. Gao and Jefferson (2007) note that countries Science and Technology launched by Joseph appear to experience an “S&T take-off” Needham and published by Cambridge when their spending on R&D doubles as a c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 201 share of GDP and begins to approach 2 per- ability to filter the good from the innocuous cent. China has doubled its spending since has declined—especially the filtering of busi - the mid-1990s and on current trends will ness model, process, and software patents exceed 2 percent by 2014. See “China Bets applications. Many if not most patents lie Big on Small Grants and Large Facilities,” dormant, never leading to any commercial Science, March 2011, p. 1251. According to outcomes. one estimate, a 10 percent increase per cap- 43. The National Patent Development Strategy ita in spending on R&D raises TFP by 1.6 (2011–20) envisages that patent applications percent over the longer term (Bravo-Ortega of all kinds will increase from 1.2 million and Marin 2011). in 2010 to 2 million in 2015 and that over- 36. China has some of the best-equipped labo- seas applications by Chinese residents will ratories in the world with state-of-the-art double. measuring and testing devices. Computing 44. See “China’s Patents Push 2010,” Nature power has also risen in leaps and bounds. News, February 15, 2010. However, foreign As of November 2010, China, with 41 of patent applications account for two-thirds of the 500 fastest supercomputers in the world, all effective invention patents (Hu 2011). was second only to the United States (IEEE 45. See “Patents, Yes; Ideas, Maybe. Innovation 2011). For a period of less than a year (2010 – in China,” Economist, October 14, 2010; 11), China’s Tianhe -1A was the world’s fast- and Li (2012), which refer to the generous est supercomputer, before being overtaken incentives that are offered to researchers and by the Fujitsu K computer. This might soon companies and also to bureaucrats in patent be eclipsed by IBM’s Mira computer. offices to approve patents, many of which 37. Installed electricity generating capacity rose are of the utility model kind. So-called junk from 350 gigawatts in 2000 to over 900 patents are not substantively examined or gigawatts in 2010 “China’s power genera- evaluated by China’s State Intellectual Prop- tion capacity leaps above 900 million kilo- erty Office (SIPO)—the patent being granted watts,” Xinhua News, September 20, 2010. with the minimum of scrutiny. Breznitz and Temporary shortages of coal and rising Murphree (2011) observe that most innova- prices constrained supply from coal-fired tion in China thus far is of an incremental plants, while inadequate rainfall reduced the sort. Firms in the ICT sector account for supply of power from hydro sources in 2011. the majority of the USPTO and many of the 38. From the Ministry of Industry and Informa- SIPO filings. These firms, according to Eber - tion Technology’s “2010 Statistical Report hardt, Helmers, and Yu (2011), tend to be on Telecommunications Industry.” young, large, R&D intensive, and outward 39. China is attempting to groom up to 100 uni- oriented. versities (including the 75 under the Minis- 46. ht tp: //transatlantic.sais-jhu.edu / bin / k /u try of Education) into top-flight, world-class /cornerstone_project_lundvall.pdf; http:// universities—through the 211 and the 985 w w w2 .d r u id.d k /con ferences /view paper programs (buttressed by the 863 and 973 .php?id=502529&cf=47 programs). Currently about 40 are being 47. OECD Factbook 2011, http://dx.doi. targeted by the 985 program. org/10.1787/888932505906. The small 40. Worldwide spending on R&D amounted to number of triadic filings also reflects the $1.1 trillion in 2007, with spending by Asian high costs. Some firms take the Patent countries surpassing that of the European Cooperation Treaty route, which estab- Union and approaching that of the United lishes a filing date and needs to be followed States (National Science Board 2010). up with national filings, but permits some 41. “China Shoots Up Rankings as Science delay. See http://en.wikipedia.org/wiki Power, Study Finds,” CNN, March 29, /Patent_Cooperation_Treaty. 2011. See also Gao and Guan (2009) on the 48. Data supplied by SIPO. increasing rate of China’s S&T output rela- 49. Ministry of Science and Technology (2008). tive to GDP growth. 50. In 2008, Huawei filed more international 42. Patenting is an unreliable indicator of inno- patents than any other company. It was also vation, and as patent offices have expe- the leading filer of patents with SIPO dur - rienced an increase in applications, their ing 1985–2006 with a 34 percent share. See 202 china 2 0 3 0 “Patents Yes, Ideas Maybe. Innovation in 55. About half of all worldwide investment in China,” Economist, October 14, 2010; and high-speed rail is occurring in China, and Eberhardt, Helmers and Yu (2011). In gen- China’s $300 billion investment in this eral, firms in the electronics industries are industry to date has created state-of-the- the most prolific patenters, in part because art production facilities. See “China’s Rail a portfolio of patents serves as protection Exports Will Survive Wenzhou Crash,” against patent infringement suits by oth- Oxford Analytica, August 24, 2011. ers and as a basis for countersuits. Patents 56. Goldwind has co-developed a direct-drive are also useful bargaining chips in highly wind turbine, which dispenses with the cost contested industries and can be a source of and inefficiencies of a gearbox. See Zhao revenue through licensing arrangements or (2011) on the development of photovoltaic outright sale. cells in China, starting in the mid-1980s 51. Some of this technology is generated by the with two silicon-cell assembly lines. firms themselves, while some is acquired 57. The first flight of the COMAC C919 is through the takeover of foreign firms. For scheduled for 2014, with an in-service target example, Dalian Machine Tools purchased of 2016. This might be optimistic in light of two businesses from Ingersoll International delays experienced by the ARJ 21 project ini- and bought a majority share in F. Zimmer- tiated in 2002, which is running five years mann. Suntech Power acquired the Japanese behind schedule. Whether the C919 can pen- MSK Corp and KSL-Kuttler Automation etrate the single-aisle airliner international Systems in Germany (BCG, “The 2009 market in the face of competition from new BCG 100 New Global Challengers,” Janu- entries from Boeing and Airbus and also ary 2009). See also Zhang, C., and others Bombardier, Embraer, Sukhoi, and Irkut, (2009). will depend on the aircraft’s performance, 52. Gwynne (2010) notes that Chinese contract COMAC’s marketing and support services, research organizations (such as Shanghai and its ability to win a few big orders from Genomics/GNI) are now offering services foreign carriers or leasing companies (Farn- ranging from the development and produc- borough, “Is China Cracking?” Flight Inter- tion of biological drugs using recombinant national, Special Report, July 3–9, 2012, DNA technology, and research on edible pp. 86–88; and “A Dogfight for Duopoly,” vaccines is on the rise. Overall, however, Financial Times, August 7, 2012, p. 7). Chinese companies hold only a limited port- 58. By 2011, China had launched more than 100 folio of pharmaceutical patents and lag in satellites for purposes of surveillance, remote this field. sensing, weather forecasting, telecommuni- 53. Measured by purchasing power parity, cations, and, most recently, navigation and China is likely to have spent more on nano- positioning via the Beidou Navigation Satel- technology research in 2011 than the United lite System. China’s Long March launchers States—$2.25 billion vs. $2.18 billion—and are now among the world’s most reliable. several recently established nanotech cen- “Chinese Academy Takes Space under ters in China are engaging in cutting-edge its Wing,” Science 332, May 20, 2011, research (Oxford Analytica 2011). On some p. 904; “Beijing Adds Fuel to Global Space views regarding the future directions of nan- Race,” New York Times, global ed., Janu- otechnology, see Manoharan (2008). ary 1, 2012, p. 3; Cliff, Ohlandt, and Young 54. See Adams, King, and Ma (2009) on China’s 2011). A space station is now in the works R&D effort. Sinovel, Goldwind, and Dong- following the docking of two orbiters, Shen- fang Electric were the top Chinese produc- zhou-8 and Tiangong-1. “China Unveils Its ers of wind turbines in 2009, ranked third, Space Station,” Science 473, May 5, 2011, fifth, and seventh in the world, respectively. p. 14; “China Forges Ahead in Space Race,” China’s BYD (Build Your Dreams) is a Nature 479, November 17, 2011. leader in high-density batteries. These and 59. This list now includes stealthy jet fighter other firms (such as the Galanz Group, the planes. See http://www.aviationweek.com HiSense Group, and SAIC) are among the / aw /g e n e r i c /s t o r y. j s p ? i d = n e w s / aw s t New Challengers in BCG’s list of 100 top /2011/01/03/AW_01_03_2011_p18-279564 firms in 2009. .xml&channel=defense. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 203 60. See also http://www.sts.org.cn/sjkl/gjscy (2002). Keller (2001a, 2001b) substantiates /data2010/2010-2.htm. earlier work by Jaffe and by others. 61. Lenovo and Haier now have the makings of 70. See Markusen (1996) on factors contribut- global brands (Nolan 2012). ing to stickiness in slippery space. Gordon 62. A full listing of national programs and and Ikeda (2011) find that the most innova - tive cities combine scale with “Jacobs den- policy initiatives from 1980 onward can be sity,” which maximizes informal contacts found in Lu (2008) and Liu, F. and others among city dwellers. (2011). An overview of China’s S&T system 71. This development, noted by Stevenson-Yang can be found in Swissnex (2011). and DeWoskin (2005), is unusual and affects 63. http://archive.itif.org/index.php?id=226. the value of intellectual property, the return 64. ht t p: // w w w. i n novat ion forde velopm e nt on manufacturing, and the speed with which repor t.org /supplement / Supplement _ IC I manufactures are commodified. _profiles2010.pdf . 72. This was the message of a major study con- 65. ht tp: //ec.europa.eu /research /innovation- ducted in the late 1980s by a group from union/pdf/iu-scoreboard-2010_en.pdf. MIT (Dertouzos, Lester, and Solow 1989). 66. The Chinese government formally adapted It is echoed in “When Factories Vanish, the “Strategy for Raising the Nation by So Can Innovators,” New York Times, Relying on Science, Technology, and Edu- February 12, 2011; emphasized by Andy cation (Kejiao Xin Guo Zhanlue) in 1995” Grove in “How America Can Create Jobs,” and established the State Leading Group on Bloomberg Business Week, July 1, 2010”; Science, Technology and Education in 1998, and reflected in a recent report to President headed by then-premier Zhu Rongji. Obama by the President’s Council of Advi- 67. See Huang, Zhang, and Zhu (2008) on the sors on Science and Technology on Ensur- footwear cluster of Wenzhou. Other clusters ing American Leadership in Advanced producing cigarette lighters and eyeglass Manufacturing. frames have also flourished, but as wages 73. “Education: The PhD Factory,” Nature 472 have risen, foreign demand weakened, and (April 2011), 2776–79. credit tightened in 2011, the Wenzhou-based 74. The reforms under way to make Shanghai’s clusters have come under considerable stress Jiao Tong University into a powerhouse with weaker firms having to exit. Less well comparable to MIT are described by Wang, known is the industry in Hebei and Shan- Wang, and Liu (2011). The making of high- dong. The so-called Gaoyang model—and caliber universities is explained in detail by its resilience through decades of turmoil—is Salmi (2010) and Altbach and Salmi (2011). described by Grove (2006). See also Kaiser (2010) on how MIT was 68. Meisenzahl and Mokyr (2011) observe that transformed into a world-class university the innovations responsible for the indus- with strong links to business. trial revolution in Britain were the work of a 75. Students from Shanghai topped the list with small band of inventors and a limited contin- a score of 575 in science and 600 in math- gent of skilled craftsmen who helped realize ematics, and although the scores from a the industrial potential of the innovations. single city are not representative, the results Lane (2009) observes that San Diego owes demonstrate the potential China can exploit 40,000 jobs in the life sciences and 12,800 through improved schooling on a nation- jobs in electronics to the research of just four wide scale. Among the measures introduced scientists at the University of California, San by Shanghai to raise the quality of educa- Diego. tion are merit pay for teachers demonstrat- 69. Adams, Clemmons, and Stephan (2006). ing results as measured by test scores, the Jaffe and Trajtenberg (1996) used patent designing of a new curriculum to prepare citations to map the diffusion of knowledge. students for tertiary-level training, its man- Others have observed that patents are only dating for all schools, and rigorous testing one of the avenues through which knowl- (“Chinese Lessons for the U.S,” Bloomberg edge diffuses from universities. Certain Business Week, April 14, 2011). informal means of communication are of 76. In purchasing parity power terms, private greater importance (Agrawal and Henderson consumption per head in China was only a 204 china 2 0 3 0 tenth of the average for OECD countries; credit from banks further encourages capital however, about 50 million households had spending (OECD 2010b). incomes that exceeded 30 percent of U.S. 85. Recruitment of Chinese and foreign fac- households (OECD 2010a). ulty members from overseas to introduce 77. This has resulted in corner cutting and envi- higher-quality talent and greater diversity ronmentally damaging practices (Midler is ongoing with the offer of generous incen- 2011). The weakening of global demand and tives; however, these efforts are producing a tightening of monetary policy to contain limited results and encountering resistance inflationary pressures has increased the pres - domestically. See the efforts by Shenzhen sures on smaller firms. Universit y, ht tp: //topics.scmp.com /news 78. This is where firms such as Lenovo have an / c h i n a - ne w s - w a t c h /a r t i c le / S he n z he n - advantage over foreign rivals such as Dell University-in-global-search-for-top-talent. and HP and why foreign firms seeking to tap 86. Plagiarism is a serious issue and one com- the Chinese market need to find reliable and mented on in leading foreign publications. savvy Chinese partners. http://factsanddetails.com /china.php?item 79. See Jorgenson, Ho, and Samuels (2010) on id=1651&catid=13&subcatid=82; http:// the contribution of IT to productivity in ser- w w w.n p r. o rg / 2011 / 0 8 / 03 / 13 8 937 7 7 8 vices. Brynjolfsson and Saunders (2009) pro- / p la g ia r is m - p la g u e - h i n d e r s - c h i n as vide additional evidence. -scientific-ambition ; http://www.nytimes. 80. This is not to deny the innovation-stimulating com/2010/10/07/world/asia/07fraud.html. effects of exports, which over the near term 87. “High-Priced Recruiting of Talent Abroad are likely to be greater than those of the Raises Hackles” Scie nc e, February 18, domestic market. However, now that China 2011, pp. 834–35. is the world’s largest exporter (and the lead- 88. Some Chinese companies have encountered ing manufacturer with 19.8 percent of global barriers when trying to acquire certain kinds output in 2010 compared with 19.4 percent of foreign high-tech firms. The latest exam - for the United States), a slowing of export ple is the opposition from the Committee growth and the concomitant restructuring on Foreign Investment in the United States of production and demand will increase the to the acquisition by Huawei of a small U.S. salience of domestic consumption on growth tech company, 3Leaf (a server technology and on innovation—possibly of a different firm), on the grounds of national security. sort. 3Leaf produces virtualization architecture 81. See Hsueh (2011) on physical assets. Half that enables commodity servers to mimic of the key national laboratories operating the capabilities of mainframe computers. in companies certified during the 11th Five Huawei eventually dropped its takeover Year Plan period are located in enterprises bid. See “Huawei Backs Away from 3Leaf owned by the central government. Acquisitions,” Reuters, February 19, 2011, 82. The contribution of managerial competence http://www.reuters.com/article/2011/02/19 and dynamism to productivity and profit- /us-huawei-3leaf-idUSTRE71I38920110219. ability is analyzed by Bloom, Sadun, and See also “Huawei: The Company that Van Reenen (2009, 2010). Brandt and Zhu Spooked the World,” The Economist, (2010) and Dollar and Wei (2007) discuss August 4, 2012, pp. 19–23, on factors con- the inefficiency of SOEs relative to their tributing to the resistance faced by Huawei. counterparts in other sectors. 89. See the suggestions in Lane and Bertuzzi 83. Although SOEs are less-efficient users (2011). of R&D resources, they have a higher 90. A comprehensive treatment of innovation ratio of invention patents to total patent policy can be found in World Bank (2010). applications. 91. Wu (2002) and Chen (2011) elaborate on the 84. SOEs also tend to use four times as much primacy of good institutions for technologi- capital per worker on average as firms in cal progress and innovation. the private sector, owing to their practice 92. The off-shoring of R&D is set to continue of reinvesting a portion of their profits to (Dehoff and Sehgal 2009). See Carlsson expand production capacity—profits not (2006) on the internationalization of R&D generally being paid out as dividends or and on the contribution of national institu- transferred to the Treasury. Easier access to tions to the process of globalization. c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 205 93. Rising costs, tightening credit, and weak- and the trend in brain gain seems to be posi- ening export demand have dampened the tive (Oxford Analytica 2009). performance and reduced the prot fi ability of 99. Some recent research on enterprise restruc- China’s 2.5 million privately owned SMEs. turing in China can be found in Oi (2011). The future contribution of this vital sector 100. This is a practice perfected by the leading Japanese firms, which, along with attention will depend on a moderation of these recent to customer feedback, accounts for their effi - trends. cient commercialization of innovations. 94. The gains from churning and creative 101. Li (2011) finds that own R&D is critical for destruction are analyzed by Fogel, Morck, the absorbing of technology—a point under- and Yeung (2008); Liang, McLean, and scored by Cohen and Levinthal (1990)—and Zhao (2011); and Bartelsman, Haltiwanger, that SOEs find it easier to absorb domesti - and Scarpetta (2004). cally generated technology than foreign 95. Popp (2010) shows how environmental reg- technology, which might be related to the ulation and standards have contributed to degree of sophistication, ease of communi- green innovation. cation, and proximity to the actual research 96. The share of R&D expenditures by firms source. This finding strengthens the case increased from 68 percent of the total in for indigenous innovation alongside inter- 2005 to 74 percent in 2009. This led to national collaboration and borrowing from a decline in the share of expenditures by abroad. The importance of a corporate cul- R&D institutions from 21 percent in 2005 ture of innovation is empirically supported to 16.5 percent in 2009. Hence, even though by Jaruzelski, Loehr, and Holman (2011). an increase in the proportion of R&D per- 102. See Mathews (2000) on the formation and formed by business enterprises is interpreted working of consortia in Taiwan, China; as a desirable characteristic of a country that and Branstetter and Sakakibara (1998) and wants to become more innovative (Mani Dodgson and Sakakibara (2003) on the util- 2010), this trend in China is partly an out- ity of consortia in Japan and elsewhere in come of its policy of converting R&D insti- Asia. OECD (2007, p. 2) comments on the tutes into business enterprises. “islands” of science in China and urges the 97. Lane (2009, 1274–75) remarks that “sci- linking together of these islands; “the gates ence investment needs to generate an ‘aha’ of thousands of science and technology moment or an idea that has value. Trans- parks [need to be] opened up through the lating that ‘aha’ moment into an innova- promotion of networks for sharing human tion also requires a well functioning team and capital resources. A greater national and or organization, a well functioning patent regional concordance would avoid waste- system, a well developed firm ecosystem, ful research duplication such as by issuing or appropriate university links to industry.” guidelines or creating an independent coor- The experience of successful firms in China dinating agency.” and elsewhere provides useful clues to how 103. On China’s regional innovation systems, see the innovative teams within firms interact Research Group on Development and Strat- with the policy and institutional framework egy of Science and Technology (2011) and in which they operate. A number of Chinese Liu, X. and others (2010). case studies are presented by Tan (2011). 104. Both house military research and production Case studies of foreign firms can be found facilities. Chengdu is one of China’s four in Herstatt and others (2006); and Boutellier space research centers and produces military and others (2000). jet planes. 98. Active recruiting of overseas ethnic Chinese 105. Zhang and Zhuang (2011) find that tertiary academics and researchers is leading to a education has a stronger impact on growth brain gain for China and helping to improve than primary or secondary education. the caliber of faculties and of research. 106. “China’s Army of Graduates Struggles for However, less than 30 percent of those going Jobs,” New York Times, December 11, 2010. abroad return, and very often the ones who 107. China’s numerous business schools, which do are not the leading lights. Nevertheless, have made a great effort to imitate Western the relative attractiveness and rewards to schools and attract academics from abroad, working in China have increased steadily, still lag behind on a number of counts, and 206 china 2 0 3 0 managerial talent remains in short supply. a specific product by orchestrating them into See “China’s Schools Must Make the Leap a remarkably flexible, agile and skilled col - Forward,” Financial Times, Sept. 26 2011, laborative supply chain. They mix and match and “Education: the PhD Factory,” Nature, the special technical skills of the partners, April 2011, p. 277. creating a network enterprise.” Collaboration 108. For example, the initial enthusiasm with needs to be encouraged at several levels. Peng cheap laptops for children in developing (2011) writes of the increasing necessity of countries is being tempered by the realiza- collaboration among scientists and observes tion that it is likely to produce results only that to catch up, China should be a more if it is combined with teacher training, a active participant on bodies such as the Inter- redesign of the curriculum, and an overhaul governmental Panel on Climate Change and of weak school systems. The mixed results FLUXNET (the global network of microme- from the use of ICT in schools are also teorological tower sites). highlighted by Machin, McNally, and Silva 115. On the problems that the U.S. Patent Office (2007), who observe that the teaching of sci- is attempting to resolve, see “U.S. Sets 21st ence and English benefited more than the Century Goal: Building a Better Patent teaching of mathematics. Office,” New York Times, February 20, 109. Linking university funding on a sliding scale 2011; and on the European system see van to the quality of outcomes is one way to spur Pottelsberghe de la Potterie (2010). innovation. The merits of online instruction 116. Suttmeier and Yao (2011, 19) observe, should not be overstated. They can be mea- “Piracy and other forms of infringement ger unless complemented by personalized remain extensive. Chinese culture still seems interaction with lecturers and with other to have trouble valuing intangible assets. students in a structured classroom setting. Elements of techno-nationalism in China’s 110. Persuading a significant percentage of the innovation policies . . . encourage suspicions best graduates and PhDs to take up teach- that that the country’s IP transition may not ing is key to achieving quality, but unless be one of harmonization. And it is difficult teaching is seen as rewarding monetarily to see how an internationally harmonized IP and otherwise, only a small minority can be system can exist where the concept of rights persuaded. (McKinsey and Company 2010). is so weakly established.” 111. Some Chinese universities are increasing 117. The number of courts equipped to handle their cross-disciplinary offerings by hir- commercial and financial litigation has also ing foreign faculty members with the req- been increased to handle a sharp increase in uisite experience; see Jane Qui, “Foreign the number of cases. Researchers Begin to Make Their Mark,” 118. On rules, policy directives and statistics, Science, July 8, 2011, p. 144. see State Intellectual Property Office, http:// 112. Experienced venture capitalists are more www.sipo.gov.cn/. likely to “bet on the jockey and not on the 119. Chinese officials and some company CEOs horse” and to want to know how many complain that certain international treaties PhDs a high tech start-up has on its payroll. that date back to the cold war era, such as 113. Wu and Zhou (2011) suggest that greater the Wassenaar Arrangement on Export autonomy for universities, allocating more of Controls for Conventional Arms and Dual- the research funding to the leading research Use Good and Technologies, deny Chinese entities, and the leveraging of science parks companies the right to purchase some tech- adjacent to research universities might yield nologies or high-end equipment. See Xue attractive dividends. Yanping, “The Wassenaar Arrangement 114. Highly successful and innovative companies and EU’s embargo on high-tech export such as Cisco eagerly pursue open innova- to China,” http://ies.cass.cn/Article/cbw tion. In fact, according to Branscomb (2008, /ozkj/201101/3394.asp. 916), “Cisco’s most important innovation is 120. The desirability of raising the share of basic its partnership with customers and competi- research (only 5.2 percent of R&D spending tors, making it a true networked enterprise. in 2006 as against 10–20 percent in OECD Li and Fung maximize the collective innova- countries) was noted by the OECD (2008). tive capacity of dozens of partners needed for Since then, basic research has received c hina ’ s Grow th throu G h t echnol o G ic al c onver G ence and i nnov a tion 207 higher priority. See Zhu and Gong (2008) 130. One explanation is that the incentives for and Nature Publishing Index (2010, p. 5). innovation by providers are much too gen- 121. Greenberg (2007) points out that maintain- erous, particularly in the United States, and ing an ethical balance becomes even more that the checks on cost escalation through the excessive use of new technologies, some important when universities draw closer of dubious efficacy, are too weak (Callahan to the business community and enter into 2009). multistrand research relationships. Trou- 131. There is a vast literature on e-medicine bling ethical issues have arisen in the United and on distance medicine in the technical States, for example, as a result of corporate journals. sponsorship of medical and pharmaceutical 132. A profiling of patients would initially be research. based on the patient’s genome, although 122. Refereeing all too often relies on the “old- later it could be done through the transcrip- boy network,” which predetermines the out- tome. This approach would enable the medi- come. Many referees drawn from scientific cal establishment to anticipate and prevent fields also struggle to cope with socioeco - diseases to which a patient might be suscep- nomic effects of new technologies. tible in the future and to develop drugs for 123. See Bonvillian and Van Atta (2011) on the currently incurable diseases. application of the DARPA approach to inno- 133. See, for instance, Henderson (2003, 2010); vation in the energy sector. Carlino, Chatterjee, and Hunt (2007); and 124. See http:/www.evaluation.fi for a measured Carlino and Hunt (2009). assessment of the innovation system in Fin- 134. A city that is top ranked with respect to land, widely viewed as having one of the high-tech and I-tech scores is Seattle, the best-performing innovation architectures. home of Boeing and also of Microsoft. The 125. See Wieser (2005) for a survey, and Lach, composition of employment in Seattle by Parizat, and Wasserteil (2008) for an evalua- subsector favors activities notable for their tion of returns from investment by the Israeli technology intensity such as aircraft and government in R&D. measuring instruments, and for IT intensity 126. “What Science Is Really Worth,” Nature, such as insurance, computer programming, June 2010, p. 683. and architectural services. Innovative cities 127. The difficulty faced by the United States in are also likely to fulfill the criteria of livabil - finding satisfactory answers for legislators ity such as good environmental quality, pub- as to the cost effectiveness of the Advanced lic services, recreational amenities, housing, Technology Program and the Small Business and connectivity. Seattle, for example, is one Innovation Research program highlights of the better run and most livable cities in the difficulties governments face as they the United States with an attractive coastal craft innovation policies that will deliver the location (Markusen and others 2004). sought-after growth and welfare dividends. 135. ARM (Advanced RISC Machines) was 128. See the extensive and many faceted discus- established in 1990 as a joint venture sions of evaluation methods in Shapira and between Acorn Computers, Apple Inc, Kuhlman (2003). The STAR METRICS and VLSI Technologies. It is the leading project is one example of a comprehensive producer of microprocessors for mobile approach to evaluating the full economic, telecommunications. scientific, and societal benefits of research. 136. Chongqing, in particular, has demonstrated Massive data assembly and number crunch- great initiative in persuading HP and Fox- ing on a scale not imaginable a few years ago conn to relocate their laptop assembly oper- is now a reality and being widely harnessed ations and support operations—the lure by industry to study all kinds of behaviors being cheaper labor and land, lower taxes and processes. These technologies, along and strengthened logistics. See “HP, Fox- with visualization techniques, could make it conn to Build Laptop Manufacturing Hub in easier to chart innovation policy and to cope Chongqing,” China Daily, August 5, 2009. with its many uncertainties (Elmer 2004; 137. However, most of the more than 600 R&D Ayres 2007). centers established by multinationals are in 129. Lancet, October 25, 2008, p. 1437. the coastal cities, chiey S fl hanghai and Beijing. 208 china 2 0 3 0 10-052, Harvard Business School, Boston, r eferences MA. Adams, James D., J. 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Given the unsustainability of cur- an average growth rate of nearly 10 percent rent economic growth in both China and a year. Over just three decades, it has devel- the world, a new approach to development oped in one giant leap from a poor country is needed. The concept of green development into the world’s second-largest economy is such an approach. Green development can after the United States. Great changes have become a potentially transformative process taken place in the quality of people’s lives. for the economy, for society, for the environ- If this trend continues, then by 2030, China ment, and for the role of government. It is an will have attained high-income status in an opportunity, an open door. unprecedented short period of time. Some Green development is a pattern of devel- consider China’s transformation as an eco- opment that decouples growth from heavy nomic miracle. But given the negative con- dependence on resource use, carbon emis- sequences of growth, it is, at best, an unfin - sions, and environmental damage, and that ished miracle. For various reasons, changes promotes growth through the creation of are needed in China’s growth model. new green product markets, technologies, First, China’s development has resulted investments, and changes in consumption not only in past high emissions, resource and conservation behavior. Green develop- consumption, and environmental destruc- ment is based on three key concepts: eco- tion, but also in external, social, and regional nomic growth can be decoupled from rising imbalances. If these imbalances are not cor- greenhouse gas emissions and environmental rected soon, they have the potential to precip- degradation; the process of “going green” itate economic and social crises. Reforms are can itself be a source of growth; and “going needed, and green development forms part green” is part of a virtuous circle that is of those necessary reforms. As income levels mutually reinforcing with growth. Green increase, the Chinese people are demanding growth is the means by which green develop- improved welfare, a cleaner environment, ment is achieved. 217 218 china 2 0 3 0 and higher quality of life—without the recur- gains, starting from its position as one of the ring risks of environment-related disasters. most energy-efficient countries in the world Second, whether China can attain high- (box 3.1). income status by 2030 is still uncertain. The current transition toward green devel- According to projections by the State Coun- opment has deep historical roots. Developed cil’s Development Research Center (DRC) countries, with 20 percent of global popula- (Liu, S. and others 2011) and other research, tion, developed during a period of high fos- China’s economic growth will slow down in sil fuel and resource consumption. Now, the the coming years, exposing yet more social remaining 80 percent of the world’s popula- and political challenges. Therefore, China tion also seeks to rise economically. However, needs to find new sources of growth, driven if the 80 percent modernizes in the same way by innovation and supported by medium- as the developed countries did—especially and high-value-added production. Green considering that by 2050 the global population development is part of the policy approach will rise to over 9 billion people—the environ- to overcoming future risks and finding new mental costs will become insurmountable for robust sources of growth. all countries. Therefore, the traditional model Third, apart from domestic conditions, of development is no longer feasible. changes in the international arena have also The global climate crisis is one of the most made it important for China to change its daunting of the crises precipitated by tradi- model of development. Western countries are tional economic growth. China will be one making the transition to a more competitive of the countries most affected by climate form of green development. As a result, a change. Therefore, addressing climate change new race toward green development is now is a pressing need for China, and a matter of being played out in the global economy, with self-interest. There is a scientific consensus significant benet fi s accruing to early movers. that to limit the rise in global average surface In 2009, the Organisation for Economic Co- temperatures to 2˚C, global carbon emissions operation and Development (OECD) issued must peak in 2020 or so, then decline dra- a Declaration on Green Growth in which matically by 2 percent a year (UNEP 2011a). its member countries set forth a comprehen- In short, there is simply not enough “carbon sive green growth strategy. Under the Euro- space” to satisfy the emission needs of all pean Union’s (EU) “Europe 2020” initiative, countries if they continue to grow in the tra- innovation and green growth form the core ditional mode of development. of a strategy to increase the competitiveness Because of rapid economic expansion, of European countries. At “Rio+20,” the and despite strong measures taken since United Nations Conference on Sustainable 2006, both China’s total annual and per Development held in Rio de Janeiro in June capita emissions are increasing at a high rate. 2012, green growth was one of the main Although its per capita emissions were histor- topics of discussion. In May 2011, Germany ically low, they are now above those of France announced that it would strive to be the first and Spain, and China’s total emissions are the industrial country to achieve a complete largest in the world (figure 3.1). During the shift to clean energy. The United States has period 2006–10, China reduced the energy issued a 10-year clean energy strategy; the intensity of its economy (a close measure to Republic of Korea has already made green carbon intensity) by 20 percent, through strict economic development a part of its national energy conservation and emission reduc- strategy going forward; Brazil has aggres- tion measures, even as it maintained overall sively merged its forward-looking policies for growth of its gross domestic product (GDP) growth, climate change, and environmental of more than 10 percent a year. China’s cur- management; and Japan is pushing for an rent commitment is to decrease its carbon additional 30 percent in energy efficiency intensity (carbon dioxide, or CO , emissions 2 Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 219 Box 3.1 Examples of national green development strategies Germany’s new energy plan. In May 2011, Germany domestic product to 10 green growth strategies, each determined to close all of its nuclear plants by 2022 containing quantitative objectives and well-defined and to become the first industrial country to shift projects. Korea also aims to increase its global mar- completely to clean energy by increasing investment ket share of green technology exports from 2 percent and research and development for renewable energy in 2009 to 10 percent by 2020. and energy efficiency. Currently, nuclear power pro - Japan’s energy efficiency strategy . Japan’s energy vides 22 percent of Germany’s electricity. To fill the intensity decreased 26 percent between 1980 and gap in its energy supply after it abandons nuclear, 2009, and it is one of the most energy-efficient coun - Germany has proposed vigorous development of tries in the world. Nevertheless, in 2006, Japan wind, solar, and biomass and new standards for pledged to improve its energy efficiency by another the thermal efficiency of buildings. It is also urging 30 percent by 2030 relative to 2006. The plan’s European and North African countries to create a continentwide super smart grid (which would allow implementation strategy fosters energy conservation the import of power from sun-rich North Africa and technologies and develops a benchmarking approach wind power from the North Sea). to monitor energy conservation. In addition to pro- Korea’s green growth plan. In response to the moting the most advanced technologies across the global financial crisis of 2008, the Republic of energy sector, the plan also introduces integrated Korea is a first mover in the implementation of green energy consumption standards for all buildings and growth. Its move toward green growth combines targets net-zero-energy houses by 2020 (which are three mutually reinforcing objectives: responding to to become the norm nationwide by 2030). Japan’s the latest economic crisis through a green stimulus, Top Runner Program tests 21 types of appliances— reducing its energy dependency, and rebalancing its ranging from vending machines and air condition- economy toward green sectors in the long term. The ers to television sets—to determine the most efficient financial crisis exposed Korea’s reliance on imported model and make that model’s level of efficiency the energy as a major weakness in its growth model. new baseline. Then, manufacturers are required to Korea imports 96 percent of its energy—account- achieve the new baseline within four to eight years. ing for two-thirds of all imports. To rebalance this Japan’s newest innovation is the concept of “smart situation by 2030, Korea aims to decrease its energy community,” a model city that maximizes the use of intensity by 46 percent and to increase the share renewable energy and relies on smart grids to deal of renewable energy in total primary energy from with its intermittent nature. Four large-scale pilot 2.4 percent in 2007 to 11 percent. Furthermore, projects were started in 2010. the latest five-year plan allocates 2 percent of gross per unit of GDP) by 40–45 percent by 2020 In sum, green development is being driven from the level in 2005. Nonetheless, China’s by harsh economic realities, changing global per capita GDP will have doubled by 2020, priorities, and growing technological possi- implying that both total and per capita emis- bilities (box 3.2). Many of the forces operat- sions will continue to rise. It is clear that how- ing in the rest of the world are also present ever global carbon budgets may be allocated in China. Chinese leadership has already through national actions and international shown its commitment to green, low-carbon negotiations over the next 20 years, there development, even though it is at the early will never be enough carbon emission space stages of a long journey. This study focuses for China to copy the past industrialization on how to achieve green development, not on model of developed countries (DRC 2009; whether it is an option. DRC Project Team 2011). 220 china 2 0 3 0 FIGur E 3.1 Emissions of Co from energy, annually and cumulatively a. Annual emissions of CO from energy b. Cumulative emissions of CO from energy 2 2 (2009 and 2030) (1900–2009 and 1900–2030) 12 500 China 2009 United States OECD Europe United States 4 OECD Europe China Russian Federation Russian Federation Japan India India Japan Brazil Canada Canada Brazil 0 0 Korea, Rep. 05 10 15 20 0 500 1,000 1,500 Tons CO per capita Tons CO per capita 2 2 Sources: World Bank. Historic emissions and population data for 1950–2009 from Boden, Marland, and Andres 2010; World Bank World Development Indicators; and UN Population Division (2011). Projections of emissions for China from 2010 to 2030 are from World Bank and DRC. Projections for emissions from other countries are from U.S. EIA (2011) and WRI CAIT (2011); population projections from UN Population Division (2011). Note: Solid dots = 2009; open dots = 2030. climate change is an important opportunity Box 3.2 Green development can help resolve to speed up economic restructuring as well as the dilemma of global emission reductions the transformation of China’s mode of devel- opment and to hasten forth a new industrial revolution” (State Council 2011). The 12th Traditional analysis shows that the benefits of cli- Five Year Plan (5YP) contains many impor- mate change mitigation are global, while the costs are tant prerequisites for China’s efforts to “go local. This asymmetry leads to difficulties in global green,” including completing the transition coordination of emission reduction. However, this to market through private sector develop- analysis fails to include the broader local benefits that ment and factor market reforms, increasing accrue to mitigation investments, such as greater eco- the share of consumption, shifting toward nomic efficiency and competitiveness and local envi - less emissions-intensive service industries, ronmental co-benefits. As governments acknowledge increasing the pace of innovation, and devel- these broader local benefits, the challenge of global emission reduction can begin to change from being a oping human capital. It also supports increas- strictly zero-sum game to one with greater win-win ing research and development (R&D) expen- potential. diture to 2.5 percent of GDP by 2015, among the highest levels of any country. Source: DRC Project Team on “Fighting Climate Change.” Transitioning to green development is critical to China’s economic competitive- ness in the future world economy. The core New o pportunities Arise of global competition lies in technological While the transition toward green develop- innovation. The 12th 5YP has a strong focus ment will not be easy, it will open the door on seven strategic industries—environmental to new opportunities. China’s government protection and energy efficiency, new energy, has already clearly stated that “addressing next generation information technology, Korea, Rep. Tons CO (billions) Tons CO (billions) 2 Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 221 biotechnology, high-end manufacturing, although that decoupling is much more clean-energy vehicles, and high-tech materi- complete in OECD countries (figure 3.2). als—which are all leading sectors for future Overall, the data show that high growth is growth. They are mostly all “green tech- compatible with lower carbon emissions, nologies” with high-value-added and export and that China and the other BRICS have potential. Growth in these areas will make an opportunity to compete by going further China’s economic structure more competi- down this path. tive. Nevertheless, while technological break- Even though the transition to green devel- throughs are essential for green growth, the opment is a long-term process, the next 20 transition to green development is a much years are a crucial strategic period for China more profound process than technological to seize the opportunity, gain competitive change. The transition will span manufac- advantages, and show global leadership. It turing and services, construction and trans- could catch up with and even surpass the port, city development and management, and United States and Europe on green measures. energy production and consumption. This If China does not seize this opportunity, is why green development would be a sig- however, then its economy will lock into a nificant break from China’s past pattern of high-emissions structure, lose competitive- development, cutting across all economic and ness, and face much higher low-carbon tran- social sectors. sition costs in the future. Mounting global evidence shows that As China positions itself to take advantage economic growth and carbon emissions and of green development opportunities, its vision pollution have already begun to decouple. can be defined by these major indicators: According to the United Nations Environ- ment Programme (UNEP), the carbon inten- • “Green” will become an important source sity of the world economy has dropped 23 of economic growth. The share of green percent since 1992. Since 1990, economic products and green services in China’s growth has increased faster than carbon GDP will be among the highest in the emissions for both the developed countries world. and developing countries, as represented by • China will become a world leader in key the five BRICS countries (Brazil, the Russian green technologies and business models Federation, India, China, and South Africa), and will be an important destination for FIGur E 3.2 Decoupling economic growth from carbon emissions worldwide a. OECD countries b. BRICS countries 320 320 280 280 240 240 200 200 160 160 80 80 1990 1995 2000 2005 2008 1990 1995 2000 2005 2008 GDP volume Real national income CO emissions from production Greenhouse gas emissions Source: OECD 2011. Note: BRICS = Brazil, Russian Federation, India, China, and South Africa. Index (1990 = 1) Index (1990 = 1) 222 china 2 0 3 0 commercializing many globally important luxury—but green development goes far low-carbon technologies. beyond the trade-off between growth and • China will have made real gains in low- the environment. New evidence shows that carbon development. The correlation the two goals—growth and a clean environ- between growth and carbon emissions ment—not only may be realized simultane- will be significantly weakened, and carbon ously but may be mutually reinforcing. When emissions will have peaked. it comes to climate mitigation, new literature • China will have adopted some of the developed by researchers in the United States world’s most stringent and wide-reaching (Acemoglu and others 2012), in Europe (Jae- environmental standards, penetrating all ger and others 2011), and in China (Zhang sectors of the economy and society. and Shi 2011) suggests it is possible to sig- • Similarly, China will have established a nificantly reduce emissions without reducing resource-efficient society. Its resource effi - long-term growth. ciency through all phases of supply, con- sumption, and recycling will be among the How Green Contributes to Growth highest in the world. • China’s cities will have low-carbon and Green development is primarily market smart transportation systems and build- driven. The prerequisite for green develop- ings. They will be livable by international ment is a sound market economy in which standards. the governmental functions to correct envi- • The quality of air, water, and natural eco- ronmental market failures through combined systems will have improved dramatically. policies, regulations, and investments. One The recovery of the natural environment can say that past unsustainable growth rep- will significantly improve both public resents the failure of government to fulfill health and natural assets. this role. Once these government actions • Low-carbon living will become wide- are introduced, the market will respond to spread and will involve all aspects of reduce environmental and social costs. Fur- people’s lives, from housing, to transpor- thermore, high-polluting, high-emitting, and tation, to food, to other consumer items. resource-intensive products will become less • The risks posed by climate change will competitive as their external costs are inter- be addressed through proactive planning nalized. These changes in relative prices will across all key sectors, including water, help push resources into industries and ser- agriculture, urban, and health. vices more consistent with green development objectives. To be specific, “green” is a source How can China turn this vision into real- of growth in three major ways. ity? What opportunities does transition to Source 1: Green transformation of tradi- green growth bring to China? How does tional sectors. A large number of existing con- going green make China more competitive? ventional techniques and management models How does it become a source of growth? can not only reduce energy use and emissions How does it improve the quality of China’s but also improve the level of corporate prot fi - economic growth? What advantages does ability. Although the greening of traditional China enjoy, and what obstacles? This chap- sectors may seem less dramatic and revolu- ter aims to answer some of these questions. tionary than the development of cutting-edge new technologies, it is clear that with infor- mation and financing, many energy-efficient Green as a Source of Growth investments are also cost-effective and yield This chapter identifies the potential oppor - high economic returns. These efc fi iency gains tunities of how green could be a source of are growth enhancing. growth. In the past, a clean environment has Source 2: Expansion of emerging green too often been considered an unaffordable in du s t r i e s . Emerging green industries Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 223 FIGur E 3.3 Index of innovation in climate change mitigation include solar and wind energy, together with technologies (1990 = 1) upstream and downstream industries such as relevant equipment manufacturing and electric vehicle industries. More broadly, however, new markets and incentives, sup- ported by innovation and research, will likely stimulate new low-carbon, resource-light, and environmentally friendly technologies, goods, and exports. In addition, increased public awareness will help shift consumer demand toward green products. Source 3: Expansion of the service sector. Services will also expand as a complement to new green product markets and changes in consumer preferences. Not only will the 1 rising share of services in GDP help reduce 1975 1979 1983 1987 1991 1995 1999 2003 2007 the economy’s carbon intensity, specialized services are likely to develop that specifically Wind power Fuel cells Electric/hybrid cells Ocean energy support green development. Examples of Solar photovoltaic Lighting energy e„ciency such services are ecosystem services, carbon Building energy e„ciency All technology sectors asset management services, carbon trading, and contract energy management. Source: Haščič and others 2010. Of course, whether green becomes a Notes: The figure shows total worldwide patent applications in EPO PASTAT database by priority date; it includes only claimed priorities (those patents for which an application is dominant source of growth will depend to a filed at an office other than the original “priority” office). great extent on future technological improve- ments, which are uncertain. Still, with stable green development policies, the pace of tech- nological innovation and investment will source of growth” (OECD 2011). According no doubt quicken, thus increasing the pos- to Jaeger and others (2011), if Europe’s emis- sibility of technological breakthroughs. For sions reduction target is raised from 20 per- example, between 1975 and 1997, growth in cent to 30 percent by 2020, Europe’s annual the number of patents for wind power, bat- rate of economic growth may increase by up tery technologies, electric vehicles, marine to 0.6 percent, generating 6 million new jobs power, solar power, and other green tech- and boosting investment as a share of GDP nologies was relatively slow. After 1997, from 18 percent to 22 percent. Beyond these with increased global awareness of climate economywide benefits, additional sector- change, more stringent environmental poli- specific benet fi s may also accrue (box 3.3). cies, and increased investment in renewable capacity coinciding with the signing of the Source 1: Green Transformation of Kyoto Protocol, the number of patents for Traditional Sectors green technologies increased dramatically (figure 3.3). Despite the unprecedented progress China Although green development is still in an has made in reducing the energy intensity early stage and the speed of development in of its economy over the past three decades, the future is highly uncertain, the oppor- a large gap between China and the high- tunities it presents are increasingly recog- income countries remains (figure 3.4). The nized. For example, the OECD’s latest Green energy intensity of China’s GDP, measured Growth Strategy points out that “green in terms of primary energy consumed per growth has the potential to solve economic unit of output, was equal to 390 tons of coal and environment problems and become a new equivalent (tce) per $1 million of output in Patent applications (3-year moving average) 224 china 2 0 3 0 Box 3.3 Further sectoral benefits of green development In addition to the three broad reasons why green • Agricultural output will be enhanced by reducing development contributes to growth, the implemen- the degradation of land and water. tation of green development policies brings several • Infrastructure constraints, particularly for han- further sectoral benefits that are growth inducing: dling coal, will be eased, and infrastructure invest- ment requirements reduced. • Rapid growth of energy consumption has strained • By anticipating climate impacts on agriculture, China’s domestic supplies of electricity, raised coal low-lying coastal areas, and areas vulnerable to prices, and made it increasingly dependent on extreme weather events, green development will imported energy. With unchanged policies, China reduce climate-related risks and improve investor may have to import 75 percent of its oil (making and consumer confidence. it the world’s largest oil importer) and 50 percent of its natural gas by 2030. Alternative energy sec- All of these measures will support growth tor policies will dramatically reduce this import through reduced costs, improved certainty, and the dependence. reduced need for risk management options. • The efficient use and better governance of land will help reduce urban congestion and sprawl. Sources: World Bank analysis; IEA 2011b. FIGur E 3.4 Energy intensity of GDP, 1990–2009 countries already pay for themselves through lower energy and input costs. Policies and investments to improve efficiency, by increas - ing returns for investments in green tech- nologies and products, will immediately add 600 to growth. For example, according to esti- mates by McKinsey & Company, installing light-emitting diodes (LEDs) for lighting in buildings could generate RMB 184 billion ($25 billion) in annual financial savings a year by 2030 compared to business as usual (measured in 2009 dollars). Improving pas- sive heating and cooling in buildings through design modifications could provide another 1990 1995 2000 2005 2009 RMB 44 billion ($6 billion). Industry was the China Korea, Rep. United States largest sectoral user of energy, accounting for Japan Germany World about 72 percent of primary energy demand in 2008 (NBS 2010b), and many efficiency Source: IEA World Energy Statistics and Balances. gains can be found there. All together, the Note: Energy intensity is the energy used per unit of GDP; PPP = purchasing power parity. potential for direct savings through efficiency gains in China could be as high as RMB 480 2009. By comparison, the primary energy billion ($65 billion) a year by 2030, if the full intensity of Germany’s economy was 173 tce technical and economic potential of these so- 4 5 per $1 million. called “no-regret” options can be realized. Whereas some new green technologies The direct benefits of these options are cost, many other technology and manage- to reduce the amount of fossil fuels burned ment changes that can help narrow the per unit of economic activity. However, they gap between China and the high-income often have co-benet fi s that add further value Ton of coal equivalent per unit (millions) of GDP (constant 2005 PPP) Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 225 FIGur E 3.5 No-regrets options for reducing Co emissions in China, 2030 Tons (millions) of CO abated 0 500 1,000 1,5002,000 Install structrural exteriors that Use farm waste as fuel reduce heating and cooling needs for cement making –50 for buildings Improve engines for light-duty vehicles Substitute clinker for additives in cement making Install better controls for district heating in buildings –100 Reuse waste heat to remove moisture from coal used to produce coke in steel making Install variable speed pumps in HVAC and water supply systems for buildings –150 Use waste gas to generate electricity for steel making Use more e‹cient appliances Install LEDs in buildings –200 Added bene‡ts to society of avoided Direct ‡nancial savings from illness from air pollution “no regrets” options Sources: World Bank calculations, based on McKinsey & Company (2009); Ho and Jorgenson (2003); Cao, Ho, and Jorgenson (2009); NBS (2009b); Liu and Wang (2011), and Matus and others (2011). Note: HVAC = heating, ventilation, and air conditioning; LED = Light-emitting diode; CO = tons of carbon dioxide. to the economy, such as improving local air in 2030, on top of the direct savings of RMB quality and thus reducing the incidence of 480 ($65 billion) a year. respiratory illness associated with air pollu- Feng and others (2011) estimate that tion; reducing infrastructure constraints in several hundred mature energy-saving tech- related sectors, such as transport and water; nologies are currently available to, but not and reducing dependence on imports of fos- fully deployed by, China’s high-energy- sil fuels. In other words, cost-effective energy consumption industries. The analysis shows efficiency and renewable energy investments that if energy-intensive industrial sectors offer triple-win (“win-win-win”) outcomes widely applied 79 of these major technolo- by trimming production costs, mitigating gies by 2020, the accumulated energy savings emissions of greenhouse gases, and improv- would be 456 million tce (with a correspond- ing public health risks in various sectors. ing reduction in emissions of 1.2 billion tons The potential for no-regrets measures to of carbon dioxide, or tCO ) (figure 3.6). If contribute to both the quantity and quality all existing and emerging energy efficiency of growth is illustrated in figure 3.5. This technologies available for energy-intensive figure shows the emissions reduction poten - industrial sectors were applied by 2020, the tial and leveled cost of certain energy effi- accumulated energy savings capacity would ciency technologies in 2030, as estimated for be 650 million–750 million tce (with corre- China by McKinsey, but adjusted to reflect sponding reductions in CO of 1.7 billion–1.9 the social value of these co-benefits. These billion tons). More detailed examples of the health-related co-benet fi s are valued at RMB cement and iron and steel sectors are given 148 billion ($20 billion, 2009 values) a year in box 3.4. Cost reduction (US$/tCO ) 2 226 china 2 0 3 0 FIGur E 3.6 Estimated energy savings and emissions reduction from installing 79 efficiency technologies in heavy industry, 2005–20 a. Energy savings b. CO emissions reductions 500 1,400 1,200 1,000 0 0 2005 2010 2015 2020 2005 2010 2015 2020 Pulp and paper Nonferrous metals Building materials Power generation Textiles Petrochemicals Iron and steel Source: Feng and others 2011. a year. Furthermore, if the State Council tar- Source 2: Expansion of Emerging Green gets are met, the contribution of emerging Industries green industries to China’s GDP will be 15 Emerging industries are green if they emit percent by 2020. low levels of pollution and greenhouse gases. Cost reductions and technological prog- The most concrete example of emerging ress in renewable energy technologies in green industries is clean energy, and some China have exceeded expectations, mostly such as solar power, wind power, biomass, due to a massive scaling-up in the industry. and hydropower have already been com- In renewable energy, the cost of both wind mercialized on a large scale. China’s seven energy and solar photovoltaic (PV) equip- targeted strategic industries, mentioned ment has decreased dramatically during earlier, are environmental protection and the past five years (Feng and Wang 2011). energy efficiency, new energy, next genera - The wholesale prices of coal-fired and wind tion information technology, biotechnology, power are already very close (just under high-end manufacturing, clean-energy vehi- RMB 0.50 or $0.08 per kilowatt hour). The cles, and high-tech materials. Globally, busi- price of a solar PV module has decreased ness opportunities in many of these sectors, from RMB 149 ($23) in 1980 to less than including clean-energy vehicles and clean RMB 20 ($3) in 2010 (U.S. DOE 2010). Fol- energy, are shifting toward the developing lowing this long-term trend, the existing gap countries. between coal-fired and solar PV power will China is now the world leader in renew- likely close by 2020. Similarly, the costs of able energy investment, surpassing all other biomass, marine power, shale gas, coal gas- countries (Pew 2010). The wind power ification, and other clean energies will con - industry alone could account for more than tinue to decrease. RMB 161 billion ($25 billion) a year in The rapid progress of clean energy tech- investment, assuming 20 gigawatts installed nologies is illustrated by the dramatic rise in Tons of coal equivalent (millions) Tons of coal equivalent (millions) Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 227 Box 3.4 Detailed analysis of two industries: Cement and iron and steel Driven by an unprecedented construction boom Chinese cement makers have made impressive over the past decade, China’s iron and steel and strides, reducing the energy intensity of production cement sectors accounted for nearly one-fourth of by 30 percent between 1998 and 2009. While now the country’s total energy consumption in 2009. As more efficient than the U.S. cement industry and on the construction boom is expected to last well into a par with Europe’s, China’s cement industry is still the 2020s, demand will continue to grow (Zhou and 30 percent above the energy efficiency level set by others 2011; Fridley and others 2011). By 2030, the the world’s best practice cement technologies. amount of coal consumed to make steel and cement China’s iron and steel industry has farther to go could reach 926 million tons a year, an increase to reach the efficiency levels of industry leaders (fig - of 276 million tons (42 percent) over 2008 (NBS ure B3.4.1). By deploying the best available technolo- 2010b; Zeng 2010; Zhou and others 2011). gies, it could save more than 100 million tons of coal a year (IEA 2010a). FIGur E B3.4.1 Comparisons of iron and steel energy intensity 2005 2006 2007 2008 2009 United States Germany Korea, Rep. 2006 2006 2006 China Sources: World Bank, based on IEA World Energy Statistics and Balances, NBS 2009b and 2010b, and UNIDO INDSTAT. Note: The figure compares tons of coal equivalent per $1 million of output in constant 2009 US$. Combined, the iron and steel and cement indus- costs. Cost savings may be even greater depending tries could achieve average net savings of RMB 73 on future energy prices. Energy-saving technologies billion ($9.9 billion) a year between 2008 and 2030 also contribute to growth by reducing the burden of by using a basket of technologies that are already pollution-caused illness to society by an estimated available on the market. This estimate includes net RMB 8.9 billion ($1.2 billion) a year over the same incremental capital, operating, and maintenance period. Sources: World Bank analysis; IEA 2011b. the number of worldwide patent filings for innovation. The number of wind power pat- wind power, solar PV, ocean energy, elec- ents granted to Chinese inventors, for exam- tric or hybrid vehicles, and lighting energy- ple, has surged within the past five to seven efficiency technologies. China occupies a years, and transfers of wind power technolo- prominent place within this global trend of gies to China from the developed countries Ton of coal equivalent per US$ (millions) output (2009 PPP) 228 china 2 0 3 0 FIGur E 3.7 Patent assignee origins for wind The growth of China’s nascent environ- power technologies mental protection industry, in particular, demonstrates the important role that the state will play in promoting the growth of United States green sectors. Take the flue gas desulfuriza - Germany tion industry, for example. Under the 11th Denmark Five Year Plan, the central government man- Japan dated that sulfur dioxide (SO ) emissions be reduced 10 percent nationwide from 2005 United Kingdom levels. This target was bolstered by addi- Korea, Rep. tional standards set by the National Devel- Spain opment and Reform Commission (NDRC) Canada and the Ministry of Environmental Protec- Sweden tion (MEP) for emissions from heavy indus- France try. As a result, China’s u fl e gas desulfuriza - tion industry has grown dramatically since China 2006. Annual installations of sulfur dioxide Russian Federation scrubbers on coal-fired power plants have Brazil increased at an average rate of 34 percent, India even with spotty enforcement of the new standards (China Greentech Initiative 2011). 0 500 1,000 1,500 2,000 2,500 3,000 By 2009, the desulfurization industry and Patent applications other environmental protection industries, More than 5 years agoPast 5 years including water treatment and solid waste disposal, were valued at RMB 480 billion Source: Chatham House 2009, cited in Feng and others 2011. ($74 billion) (Lan 2011). With stricter stan- Note: BRIC = Brazil, Russian Federation, India, and China. dards introduced under the 12th Five Year Plan, the government hopes that the environ- over the past two decades have exceeded any mental protection industry can grow to RMB other country (figure 3.7). As China contin - 2 trillion by 2015 ($310 billion) (box 3.5). ues to absorb and innovate new green tech- Green emerging industries also create nologies—supported in part by government exports and jobs. By 2030, the projected investment and policies—these technologies exports of green technologies and services will become increasingly competitive and specifically related to renewable energy and contribute to the country’s growth in the clean energy (mainly electric) vehicles is pro- upcoming years. jected to rise to RMB 1.691 trillion–2.916 Box 3.5 r obust growth projected for China’s environmental protection industries In a speech in November, 2011, at the APEC (Asia what was invested over the previous 5 years. Chi- Pacific Economic Cooperation) Summit, President na’s energy conservation and environmental protec- Hu Jintao announced, “Continued rapid growth tion industries are seen as major sectors for foreign is projected for China’s environmental protection investment. A flourishing demand for ‘green’ prod - industry during the 12th Five Year Plan (2011–15). ucts and services, combined with a favorable invest- By 2015, the total value of the industry may exceed ment environment will provide a vast market and RMB 2 trillion. Between 2011 and 2015, China’s tremendous opportunity for enterprises from around central government plans to invest RMB 3.1 trillion the world. . . .” in protecting the environment, more than double BRIC countries Top 10 OECD countries Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 229 FIGur E 3.8 Projected annual Chinese exports of green products trillion ($229 billion–$395 billion, measured and services (2030) in 2009 dollars) in export sales (figure 3.8) and lead to 4.4 million–7.8 million new jobs. These export sales are on the order of 6–10 percent of total projected exports, or 2–3 percent of projected GDP. Of course, this large scale-up is driven by global demand and depends on decisive action to address climate change by the world’s governments. As a driver of growth, green clearly cre- ates jobs. But green also implies some higher costs, industrial restrictions, and layoffs as well as government actions that lead to Wind Solar Other Clean energy Green changes in prices and production patterns. turbines photovoltaic renewables vehicles services The positive impact on employment is greater Existing policies Ambitious policies the longer the time frame being considered and the wider the definition of green jobs Source: World Bank calculations. being used. A recent study under the China Note: The ranges given above compare two scenarios defined by the International Energy Council of International Co-operation on Agency (IEA). The “existing policies” scenario is one in which the G-20 countries follow through with their commitment to reduce fossil fuel subsidies, countries fulfill their Cancun Environment and Development (CCICED Decision pledges to reduce greenhouse gas emissions, and other existing CO mitigation 2011) estimates that government spending of policies are implemented (that is, the “New Policies” scenario in IEA 2010b). The higher estimates correspond to the scenario in which countries take ambitious action to prevent RMB 5.8 trillion ($910 billion) on measures atmospheric concentrations of CO from rising above 450 parts per million (that is, the “450” to save energy, protect the environment, and scenario in the IEA 2010b). replace polluting industries with high-tech firms would create 10.6 million jobs over the next 5 to 10 years. In contrast, eliminat- increased exports of certain green technolo- ing the dirtier sectors of the economy would gies. Although approximate, all of these esti- lead to the loss of 950,000 jobs. The previ- mates confirm the notion that the net trade- ous paragraph noted that 4.4–7.8 million offs favor green as a source of job creation new jobs may be created by 2030 through (box 3.6). Box 3.6 The relationship between green development and employment Empirical research done in other countries has con- the overall economy (Muro and others 2011). A cluded that in the medium term, green growth will study in Germany found that implementing mea- have a positive but small net effect on the number of sures to mitigate climate change led to more job jobs in the global economy (UNEP 2011b; Marti- opportunities for college graduates (cited in Dupres- nez-Fernandez and others, 2010; ILO 2009; Dupres- soir and others 2007). This finding is linked to the soir and others 2007). Within this overall scenario, higher component of innovation found in newer of course, some countries, such as China, will excel technologies than in more traditional ones. In con- in creating green technology jobs. Furthermore, evi- trast, extractive industries, utilities, marine fisheries, dence from developed countries also suggests that and some heavy manufacturing industries are likely those jobs that are created in the transition to green to shed jobs over the upcoming decades, primarily growth are often skilled and high paying. A recent as a result of gradually increasing energy prices, nationwide study of green industries in the United depleted natural capital (such as overexploited fish - States revealed that the median wage in these indus- eries and forests), more efficient technologies, and tries is 13 percent higher than the median wage in the automation of production processes. US$ 2009 (billions) Low- income countries 230 china 2 0 3 0 China, where farmers on marginal lands are Source 3: Expansion of the paid to maintain the ecosystem rather than to Service Sector sell wood or other crops. The green transformation will impact the China’s traditional service sector is lagging service sector in two ways. First, it will give and has significant room to develop. In 2010, birth to new green service industries, such the share of services in total value added as ecosystem services, carbon asset manage- was 43 percent, a figure that is much lower ment services, carbon trading, and contract than the average for high-income countries energy management. Second, it will sup- (75 percent), and even lower than in most port the country’s intended economic rebal- middle-income countries (52–54 percent in ancing away from heavy manufacturing and 2010) (World Bank, World Development toward a larger service sector. Both trends Indicators) (figure 3.9). are important for reducing China’s carbon Several reasons explain the low share of footprint, as its efficiency in manufacturing services in China’s economy. First, the level of may soon approach or even surpass the levels government public service is very low, partic- of high-income countries. ularly in the less developed regions. Histori- The emerging green service sector is cally, the role of government has focused on already important. According to a trade asso- facilitating economic growth more than on ciation of energy conservation service provid- providing social services. Second, government ers in China, at the end of 2010, the total overregulation and in some cases monopoly value of China’s energy conservation service has restricted development of the service industry was RMB 80 billion ($12 billion). industry and has inhibited the flow of private The industry reduced power consumption capital into these sectors. This is particularly by 10.6 million tons of coal each year and true in finance, insurance, navigation, rail- reduced greenhouse gas emissions by 26.6 way, telecommunications, petroleum, power, million tons of CO . Another important education, medical services, entertainment, trend is that ecosystem management services sports, and the arts. Third, China’s export- are a growing industry in some poor areas of oriented development strategy has meant FIGur E 3.9 Services, value added, as a share of GDP (2010) 70 71 China High-income Upper- Lower- France United Japan Germany Korea, countries middle- middle- States Rep. income income countries countries AgricultureIndustryServices Source: World Bank World Development Indicators 2011. Note: Agriculture corresponds with ISIC (International Standard Industrial Classification) Rev. 3.1 divisions 1–5, covering forestry, fishing, livestock production, and the cultivation of crops; industry includes divisions 10–45, covering mining, manufacturing, construction, and utilities; services are defined as divisions 50–99, which cover wholesale, retail trade, transport, government, financing, professional services, education, health care, and real estate. Data for France and Japan are from 2009. % of GDP Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 231 that local government has been dependent the precedent of the eastern provinces by on large-scale, capital-intensive industries for growing first and then cleaning up later. This tax revenue, and there has been less support is especially true for those central and western to the service industry. All of these forces are provinces with abundant mineral resources. weakening, thus favoring the long-term devel- Although extractive industries may have led to opment of China’s service industry. high GDP growth rates, the income levels of China’s service sector growth over the people living in these regions has not grown long term will depend on the pace of reform commensurately, and in some places, the natu- of government restrictions, policies favoring ral environment has been severely degraded. the knowledge industries, and consumption The interior provinces should avoid the patterns of the rising middle class. The ris- conventional (and environmentally degrad- ing share of services in GDP will help reduce ing) growth path of the east for several rea- the economy’s carbon intensity. According to sons. First, the ecological environment of estimates by the DRC, the energy intensity of the interior provinces is relatively fragile output (value added) by secondary industries compared with the east, and the costs of in 2009 was eight times higher than agricul- “clean up later” would be prohibitive. Sec- ture and five times that of services. Every per - ond, China’s population is aging rapidly. As centage point increase in the share of services the surplus agricultural labor force that filled in GDP is associated with a decline in energy the factories of the east gradually shrinks, it consumption of 1.4 percentage points. will become impossible to sustain the kind of labor-intensive growth observed over past decades. Third, as China introduces Additional o pportunities for China’s more stringent policies to conserve energy u nderdeveloped r egions and reduce greenhouse gas emissions, the The green development approach can help potential for growth from high-emissions, reduce China’s interregional inequality by resource-intensive industries will be limited. helping its relatively underdeveloped central The interior provinces have a strong com- and western regions catch up. Although his- parative advantage in clean energy resources torically the eastern provinces always led in (State Grid 2010). Fourth, with rapid expan- economic development, since 2005, growth sion of cities onto increasingly scarce land, rates in the central and western regions have the national government has imposed stricter overtaken the east (Liu and He 2011). How- controls on the use of land for industry (box ever, the interior provinces should not follow 3.7). Thus, China’s underdeveloped regions Box 3.7 China’s “Main Functional Area Development Plan” To protect the environment and avoid “polluting the rights of different regions to development con- first and cleaning up later,” China’s State Council tains elements of a planned economy. Controversial launched the “Main Functional Area Development aspects aside, the plan represents stringent environ- Plan” in 2010. This plan divides all of China’s land mental regulation and will prevent certain regions area into four major types: relatively affluent, indus - from following the more traditional path to devel- trial, urbanized areas where development should be opment. Without the plan, local governments would “optimized” to solve existing environmental prob- likely be unable to implement such strict environ- lems; key areas for future development; areas where mental policies. Thus, by limiting or prohibiting the development should be limited; and areas where development of certain regions, the Main Functional development is prohibited. These classifications are Area Development Plan will encourage these regions somewhat controversial: for example, restricting to take a new path to green development. Source: DRC. 232 china 2 0 3 0 Box 3.8 A “Big Push” model for green growth in poor areas: The case of Hunan Huaihua in Hunan Province is endeavoring to take ing a “big push” to utilize new market mechanisms full advantage of improved transportation, telecom- and build green economies that include conference munications, and logistics networks to pursue a new centers, medical services, and eco- and cultural tour- strategy for economic growth. The previously under- ism. A more productive division of labor is evolving, valued intangible resources of the Wuling Mountain with the local population benefiting as both farmers Area, such as its beautiful natural environment and and service providers. The slogan of this experiment, rich cultural heritage, will provide a new source of “Villages Making Life Better,” suggests that villages income for local people and help promote local eco- will no longer represent poverty in China but will be nomic growth. a symbol of a high-quality lifestyle. More important, Through the coordinated efforts of government the models are duplicable elsewhere. and private entrepreneurs, poor regions are mak- Source: DRC. have a direct interest in growing green while to better connect a poor county of Hunan avoiding the cleanup costs being incurred by Province with the market economy (box 3.8). the eastern provinces. Elsewhere in China, other examples of green Because their economies are currently less development are appearing every day. Search- developed, many ecological, environmen- ing out different forms of green development tal, and cultural resources of these regions that are suited to local conditions has great have been preserved. With high-speed rail, importance not only for China but for other highways, improved logistics, the Internet, poor countries as well. and other telecommunication technologies, the relationship between urban locations Green Improves the Quality of and economic development is changing. By Growth capitalizing on better connectivity, the hith- erto undervalued environmental resources People’s welfare includes such concepts as of China’s interior regions may provide eco- good health, quality of life, and a clean envi- nomic benefits that enable them to grow in ronment, in addition to income. While some a way that does not require sacrificing their of these welfare concepts are not quantie fi d in environment. traditional measures of GDP, they can, never- Many underdeveloped regions of China are theless, be measured. Improving the “quality now pushing to develop in new ways, in areas of growth” implies improving some or all of such as high-value-added agriculture, eco- these welfare measures. Even though China’s tourism, cultural tourism, training and con- current levels of environmental degradation ference centers, health care centers, and the and resource pollution, measured as a share arts. Some of these innovations require new of gross national income, are much higher business models, such as franchise businesses than in high-income countries, China has that draw on local labor. Important oppor- already made great strides in improving these tunities exist for payments for ecosystem ser- welfare measures. This section addresses the vices as well as for installations of renewable magnitude of the welfare gains that can be energy. For example, farmers in some poor made through green development. It also parts of China have already transitioned from indicates that some improvements in envi- selling timber to marketing ecosystem services ronmental quality are necessary investments to earn a living. Another example is the more that will benet t fi he quantity of growth in the complicated “big push” that is being piloted medium and longer terms as well. Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 233 FIGur E 3.10 Environmental and natural resource degradation and Improving the Quality of China’s depletion, 2008 Growth by r educing Environmental Degradation Green development will reduce China’s cur- rent high costs of environmental degradation 6 and resource depletion, which is crucial for 4 its continued growth and well-being. Under 2 no scenario can China achieve the quality of growth that is already articulated in its 12th China India Brazil United Korea, Japan Germany States Rep. Five Year Plan and longer-term social and economic targets without dramatic improve- Sources: World Bank World Development Indicators 2011; World Bank 2007; Shi and Ma 2009. ment in the use and sustainability of its natu- Note: Here, environmental degradation includes damages from CO , small particulate matter (PM ), and water pollution. Damages from CO are estimated at $20 per ton of 10 2 ral resource base. The experience of Japan carbon (the unit damage in 1995 U.S. dollars) times the number of tons of carbon emitted. shows that stringent environmental poli- Damages from PM are calculated as the willingness to pay to reduce the risk of illness and death attributable to particulate emissions. Damages from water pollution for China cies do not interfere with economic growth. are from 2003 and are based on estimates of health damages, calculated by monetizing In fact, they may even catalyze growth. premature mortality from diarrheal disease and cancer associated with water pollution and morbidity from diarrheal disease associated with water pollution (following World Intervention-style environmental policies play Bank 2007). Natural resource depletion is the sum of net forest depletion, energy depletion, an important role in this (Kobayashi 2011). mineral depletion, and soil nutrient depletion. Net forest depletion is unit resource rents times the excess of roundwood harvest over natural growth. Energy depletion is the ratio Economic growth and improving the qual- of the value of the stock of energy resources to the remaining reserve lifetime (capped at ity of the environment thus may be mutually 25 years). It includes coal, crude oil, and natural gas. Mineral depletion is the ratio of the value of the stock of mineral resources to the remaining reserve lifetime (capped at 25 reinforcing. years). It covers tin, gold, lead, zinc, iron, copper, nickel, silver, bauxite, and phosphate. Soil The overall environmental benefits from nutrient depletion data come from Shi and Ma 2009. green development can be substantial. At China’s current level of development, the TABLE 3.1 Getting to a greener China environmental degradation and resource Percent of GNI depletion in the country is valued at approxi- Environment depletion and  2009 “Greener” value, Net mately 9 percent of gross national income degradation value reachable by 2030 improvement (GNI), more than 10 times higher than cor- Energy depletion 2.9 1.9 1.0 responding levels in Korea and Japan (figure Mineral depletion 0.2 0.2 0.0 3.10). A successful path of green develop- PM health damage 2.8 0.1 2.7 ment would cut this value, by 2030, to the Air pollution material damage 0.5 0.1 0.4 much lower level of 2.7 percent of GNI a year Water pollution health damage 0.5 0.1 0.4 Soil nutrient depletion 1.0 0.1 0.9 (comparable to current levels in the United Carbon dioxide damage 1.1 0.2 0.9 States)—at an estimated additional cost of Total depletion and degradation 9.0 2.7 6.3 0.5–1.0 percent of GNI a year beyond cur- Sources: http://data.worldbank.org; World Bank 2007; Shi and Ma 2009; World Bank analysis. rent spending on environmental protection. Note: PM = small particulate matter. While some of the benefits of this level of investment in the environment come in the form of financially viable “win-win” invest - externalities are internalized as efficiently as ments, others would take the form of eco- possible in consumption, production, and nomically viable investments in public wel- investment decisions throughout the econ- fare and ecological health. omy. Prices of natural resources and key fac- China’s specific environmental improve - tors of production will need to reflect scar - ments would come from reducing reliance on city value as well as environmental costs and fossil fuels, and achieving the lower levels of benefits. Green development, such as reduced air pollution, water pollution, and resource reliance on fossil fuels, will improve local depletion associated with high-income coun- environmental outcomes—such as reduced tries (table 3.1). The best way to achieve these air pollution, land degradation, and water improvements is to ensure that environmental contamination. % of GNI 234 china 2 0 3 0 The largest part of the projected improve- air pollution. But despite improvements ment would be the economic benefits asso - in urban air quality, the urban population ciated with improvements in human health has grown so much that the total health and material damage from reduced air pol- costs associated with air pollution, and the lution. China faces one of the world’s highest exposure of the population most at risk, the current and projected burdens of environ- elderly, continue to rise (figure 3.11). mental disease linked to urban air quality A strong commitment to dealing with con- (Cohen and others 2004; World Bank 2007). centrations of particulate matter in cities will Trends in urban air pollution are improving, pay large dividends in improving health and but the impact on health is still extremely social welfare. As China continues to grow, large—nearly 3 percent of GNI in 2009. it will be possible to reduce air pollution lev- The government has responded strongly els dramatically—just as Japan did starting in recent years to address the problem of in the mid-1960s (figure 3.12). That is when FIGur E 3.11 u rban air pollution trends in China, 2003–09 a. Trends in PM b. Total value of excess mortality and morbidity linked to PM exposure 140 800 2003 2004 2005 2006 2007 2008 2009 2003 2004 2005 2006 2007 2008 2009 Source: World Bank analysis based on China Environmental Statistical Yearbook. FIGur E 3.12 Average annual So and No concentrations observed for the 10 largest cities in Japan and 2 2 China, 1970–2009 a. Average annual SO b. Average annual NO 2 2 Chongqing Beijing Shanghai Japan, national average Japan, national average Beijing Chongqing Shanghai Sources: NIES database; Japan Ministry of Environment (1989); Kawasaki Air Pollution Monitoring Center; NBS, China Environmental Statistical Yearbook, various years; city statistical yearbooks for Beijing, Tianjin, Shenzhen, Chongqing, and Nanjing, various years. Note: Includes 10 largest cities in Japan by population in 1970; 10 largest cities in mainland China by downtown population in 2009 (excluding Dongguan City, Guangdong). NO = nitrous dioxide; SO = Sulfur dioxide; µg/m = micrograms per cubic meter of air. 2 2 Concentrations µg/m , urban population weighted yuan (billions), reference year 2000 µg/m µg/m Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 235 Japan’s air quality and other environmental critical water shortages in the north and concerns reached crisis levels, and when it too northeast, where freshwater resources are only was an upper-middle-income country. If air 785 cubic meters per capita, about 200 cubic quality in China were brought to the level of meters below the international standard for Japan in 1980, these benet fi s would be valued “severe water stress.” With the urban popu- at 3.1 percent of GNI. In addition, these air lation growing by nearly 300 million over the pollution improvements would bring large co- next two decades, the stress on existing sup- benet fi s associated with reduced use of fossil plies will only increase. Cleaning up China’s fuels, such as reduced depletion of fossil fuel water supply is a clear priority (box 3.9). resources, improved water quality, improved Land degradation presents a similar prob- soil quality, and reduced CO emissions. lem of scarcity. Heavy use of agrochemicals, Pollutants in water and soil also affect pub- combined with pollution from cities and lic health both directly and through the food industry has degraded soil quality. Accord- chain. About 40 percent of the water sampled ing to the Ministry of Environmental Protec- from the major rivers in the north and north- tion and the Chinese Academy of Engineer- east is at Grade V or V+, making it unsuitable ing, heavy metal contamination of farmland for most uses, whether recreational, agricul- is a serious issue raising concerns that these tural, or industrial. This exacerbates already pollutants can make their way into the food Box 3.9 The challenge of China’s water pollution China’s surface and groundwater supplies are low on FIGur E B3.9.1 Wastewater emissions projections a per capita basis, but useful supplies are much lower (Co D), 2005–50 yet because of pollution. Although seen most vividly in pictures of an algae-choked Lake Tai, across water- stressed North China, 40 percent of the rivers fall into the two worst water quality categories (Grades V and V+), meaning direct use would endanger health. Water treatment is very expensive. The government has nec- essary, but ambitious, targets to control pollution: Ministry of Environmental Protection Targets • By 2020: 60 percent of China’s surface waters meet the standards for Grades I–III (compared to 57 percent in 2009) 2005 2010 2020 2030 2050 • By 2030: 70 percent of China’s surface waters meet the standards for Grades I–III High emissions Medium emissions Low emissions • By 2050: 80 percent of China’s surface waters meet 2020 targets 2030 targets the standards for Grades I–III. Source: MEP and CAE 2011. Note: Chemical oxygen demand (COD) is an indirect measure of the severity of water pollution Based on global experience, success in improv- ing water quality will depend on a combination of aggressive regulatory monitoring and enforcement to reduce those sources of pollution, the country will with a strong set of economic incentives. China’s need to tackle the even more difficult problem of interventions to date have focused on industrial and municipal point-source pollution. While continuing nonpoint sources. Tons (millions) 236 china 2 0 3 0 chain (MEP and CAE 2011; Yang 2011). The climate mitigation, and local environmental presence of contaminated arable land may benefits. McKinsey estimated the potential also restrict land availability for agriculture, cost savings of these no-regrets low-carbon which is already severely limited because investments available in China to be on the of pressures from urban, industrial, and order of $65 billion a year by 2030. However, infrastructural development. Indeed, total the co-benefits of these investments associ - agricultural land may drop below the amount ated with improved productivity of China’s mandated by the government as “the red workforce, thanks to fewer cases of respira- line” below which self-sufficiency in grain tory illnesses each year, puts additional eco- production will be hard to maintain. nomic gains at around RMB 148 billion ($20 billion) a year (measured in 2009 US$). The magnitude of various other potential “win- Environmental Co-Benefits of win” strategies to improving public health is Green Development highlighted in table 3.2. Of these examples, As highlighted in the previous section, there more efficient buildings that require less coal are investments and management improve- to be burned for electricity would generate ments that are cost effective (assuming effi - the largest health-related co-benet fi s (as much cient markets), emissions reducing, and pol- as $9 billion), followed by the use of additives lution reducing. These “no-regrets” cases in place of clinker in cement production (as contribute, therefore, to economic growth, much as $2.7 billion). TABLE 3.2 Direct savings and additional co-benefits of annual reductions in C o emissions, 2030 ($, millions per year) Additional benefits Direct savings from from avoided Sector Cost-saving abatement option reduced costs air pollution Buildings Replacing old bulbs with LEDs 24,992 2,364 Appliances 9,007 978 Efficient variable speed water pumps 3,453 750 Water heating 2,085 489 District heating controls 1,439 1,125 Efficient buildings 6,116 8,967 Transport Light-duty vehicles, efficient combustion engines 5,018 950 Industry Combined-cycle power plants (steel) 5,630 745 Coal moisture control (steel) 2,085 827 Utilizing or destroying coal bed methane (mining) 751 0 Clinker substitution (cement) 229 2,669 Agriculture/forestry Fertilizer management 2,280 162 Cropland management and restoration 1,112 0 Methane utilization 834 0 Total 65,030 20,027 Sources: World Bank analysis, based on McKinsey & Company 2009; NBS 2008a, 2009a, 2009b; Ho and Jorgenson 2003; Cao, Ho, and Jorgenson 2009; Liu and Wang 2011; Matus and others 2011. Note: Figures are expressed in 2009 dollars. For this table, a sector-by-sector estimate was made of the local environmental co-benefits associated with energy efficiency investments. These co-benefits include the avoided costs of respiratory illnesses due to reduced air pollution, which is correlated with reduced burning of fossil fuels. For some industries, such as iron and steel and cement, most greenhouse gas emissions can be attributed to burning coal. For others, such as the transportation sector, the emissions come mainly from burning oil. Since certain fuels are “dirtier” than others, reductions in use have different impacts on local ground-level air pollution. A Chinese Academy of Sciences study calculated the fuel mix used by each industry type (Liu and Wang 2011) and estimated how many units of coal, oil, and natural gas were saved by reducing greenhouse gas emissions with the technology options in the McKinsey marginal abatement cost curve (McKinsey 2009). Damage estimates were taken from studies done by Harvard and Tsinghua University economists (Cao, Ho, and Jorgenson 2009; Ho and Jorgenson 2003) of the marginal cost of increasing people’s exposure to higher concentrations of pollutants. The sum of the benefits from reduced coal, oil, and natural gas combustion for each abatement option gives the total estimated value of avoided illness. a. Includes passive design, retrofit packages for commercial buildings, and other design improvements. Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 237 Over the longer term, to improve its envi- The Benefits of Investing in ronmental quality, China’s government expen- Environmental Protection ditures related to the environment should be at What are the costs China will face as it deals least 0.5 percent of GDP above current levels. with the challenge of reducing the degrada- Any increased environmental expenditure in tion of its natural assets (measured as a share China would include increased spending both of GNI) and makes targeted increases in on pollution abatement and on efforts to pro- spending on environmental protection? It is tect and restore the health of its ecosystems. clear that cleaning up China’s environment Although China is already spending RMB requires resources; otherwise, it would have 83.7 billion ($13.0 billion) each year on tree been done already. planting programs to combat soil loss, flood - Current annual investment in the treat- ing, and desertic fi ation, the cost-effectiveness ment of industrial pollution in China—about of these programs can be improved by setting 0.15–0.20 percent of GDP—is roughly com- targets based on ecosystem health rather than parable with the amount spent in several on acres of forest planted. It can also direct European countries each year. Considering more investment to relatively neglected areas, how fast China’s economy has grown over such as the conservation and restoration of the past decade, this spending reflects a great wetlands and coastal ecosystems. effort to reduce pollution, especially point- Evidence from the United States and else- source pollution from industry. where shows that such expenditures have Overall, however, cleaning up industrial extremely high rates of return when mea- pollution is a relatively small fraction of sured in economic terms (for example, the total environmental protection expenditures benefit-cost ratio of the U.S. Clean Air Act by government and business in high-income is projected to be 25:1 by 2015 and 31:1 by European countries. When the full range of 2020) (U.S. EPA 2011). Increased environ- environmental protection activities defined mental expenditure in China would have in the European System for the Collection of similar high rates of return by increasing nat- Economic Information on the Environment ural and human capital in the economy. By (EC 2002) are included, high-income Euro- this account, a relatively modest incremental pean countries spent about 0.3 percent to 1.1 increase in environment-related expenditures percent of GDP more than China on envi- would go a long way toward securing the ronmental protection overall, measured as a gain in social welfare of 6.3 percent of GNI share of GDP in 2008 (table 3.3). shown in table 3.1. TABLE 3.3 A comparison of total environmental protection expenditures, 2001–09 As a share of GDP 2001 2002 2003 2004 2005 2006 2007 2008 2009 China — — — — — — — 1.23 — France — — — 2.07 — — 2.16 — — Germany 1.73 1.70 1.69 1.70 1.51 1.62 1.53 — — Hungary 1.68 1.76 1.85 2.00 2.14 1.95 1.59 1.52 — Italy — — — — — — — — — Poland — 1.75 1.78 1.74 1.79 2.04 2.06 2.38 2.42 Portugal — — — — — 1.12 1.25 — — Spain 1.48 1.55 1.56 1.54 1.61 1.69 1.78 1.83 — Sweden 1.19 1.19 1.18 1.16 1.26 1.20 — — — EU-25 1.90 — — — — 1.82 — — — Sources: World Bank calculations based on Eurostat 2010, Eurostat database, OECD 2008, NBS 2010a, MEP and NBS 2010, MOF 2009, SFA 2009, Wang and others 2010, Chang and others 2010, and Wu and others 2007. Note: — = no data. 238 china 2 0 3 0 the country where there is more indigent pov- Adapting to a Changing Climate by erty, other areas may actually benefit from Increasing r esilience to r isk night-time warming, longer growing sea- A further benefit that green development sons, and increased water available to irriga- would bring to the quality of China’s growth tion systems (Wang, J. X., and others 2008, is increased resiliency to climate risks. Chi- 2010). Coping with the significant variabil - na’s climate is already changing, and changes ity of future impacts will require geographic are likely to accelerate in coming years. Even shifts in production and more flexible and taking into account current scientific uncer - robust water management. tainty about the extent and nature of future Urban populations and industry will also climate change impacts, preparedness for a be more exposed to extreme weather events. more variable, unpredictable, and extreme Much of the population lives in areas where future climate will be a prerequisite for sus- sea-level rise, storm surges, flooding, and tained economic growth. Adopting planning tropical cyclones are a concern (figure 3.13). and investment approaches to better address Indeed, economic damages from typhoons, risks and uncertainties is a reason for China floods, and other severe weather events are to fully incorporate climate change in its eco- already high: losses from typhoons alone nomic management. in China averaged RMB 8.4 billion ($1.3 Among the observed effects of climate billion) each year from 1994 to 2005 (Guy change are average annual surface tempera- Carpenter 2006). As the concentration and tures increased by 1.38˚C between 1951 and value of productive capital and valuable 2009 for the country as a whole and much faster in the north and northeastern prov- FIGur E 3.13 Vulnerability to sea-level rise and inces (NARCC 2011). The number of rainy storm surges by country, circa 2000 days has decreased for most regions, and more precipitation has come from shorter, more intense storms (Di and others 2007; China Zhai and others 2005). The area of cropland India exposed to drought has also increased for Japan many regions. In the years to come, despite Indonesia United States more rainfall projected for China as a whole, Bangladesh many regions may actually suffer from more Vietnam droughts (Woetzel and others 2009). Agri- Thailand culture will be particularly hard hit, because Egypt, Arab Rep. precipitation will come during the winters Netherlands and less during the crucial spring and sum- Brazil Philippines mer months. The area of cropland affected Ukraine by flooding each year has increased signifi - Myanmar cantly for parts of the Yangtze River basin. Nigeria Although the projections are highly uncer- Italy tain, flooding may continue to increase for Argentina Germany this region in the coming decades (NARCC Malaysia 2007; Ren and others 2008). Mexico The agricultural sector is likely to have 0 10 20 30 40 50 60 70 80 the greatest early climate change impacts. Urban population (millions) in Annual crop losses due to drought in the low-lying coastal areas Northern China plain and northeast prov- inces are projected to rise (Nelson, Ye, and Sources: World Bank 2008; McGranahan, Balk, and Anderson 2007. d’Croz forthcoming). While warming will Note: Low-lying coastal areas are defined as “the contiguous area probably hurt rain-fed agriculture in parts of along the coast that is less than 10 meters above sea level.” Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 239 TABLE 3.4 China’s unique advantages and infrastructure increase in these areas, so challenges in green development will potential damages. This is particularly worrisome for long-term capital assets, such Advantages as power grids, water supply and wastewa- 1. Government ability to mobilize action on high-priority ter treatment systems, and road and rail issues networks. 2. The advantage of being a relative latecomer Institutions, planning processes, and 3. Large domestic market in which to scale up green sectors policies that effectively manage future risk 4. Abundant capital (including human capital) to invest in through green development will increase the green sectors resilience of China’s economy. In turn, China 5. Natural endowment of resources for clean energy will be able to mitigate, recover quickly from 6. Potential to still avoid lock-in effects of higher levels of damage caused by adverse weather, and be urbanization 7. A destination for global investments and R&D in green ready to seize new opportunities for growth technologies should these arise. For example, long-term glacier melt on the Himalayan plateau will Challenges generate both enormous challenges and 1. Distorted prices of resource commodities opportunities for water conservation and 2. Overreliance on administrative measures for reducing carbon emissions storage technologies. Opportunities for both 3. Weak incentives for environmental protection domestic and international gain abound in 4. Lack of a competitive market environment for green other sectors as well, such as agriculture, sectors building design, and infrastructure design. 5. Sector coordination failures 6. Weak monitoring and enforcement of environmental standards, especially at the local level Factors Favoring and Impeding Green Development in China In pursuing green development, China enjoys Five Year Plan, in which the State Council a number of unique advantages that other (2011) makes clear that “addressing climate countries do not have. At the same time, it change will accelerate economic restructur- also faces unique challenges (table 3.4). The ing and the reform of economic development, largest of these challenges is not a lack of driving forward the opportunities of the next financing but rather a lack of incentive struc - industrial revolution.” tures to promote green development. If China Beyond expressions of commitment, can overcome these challenges in the next the government has demonstrated numer- two decades, then it could position itself as a ous times that it can take decisive action on world leader in green development. issues of high political and economic prior- ity. Reforms undertaken over the past three decades have fundamentally redefined the Factors Favoring Green Development functioning of the Chinese state in allow- in China ing the market to play a greater role. Green First, government has the ability to mobilize development is consistent with further mar- action on high-priority issues. China’s top ket reforms that promote efficiency, while leaders have already reached a high level of increasingly correcting for market externali- consensus on the importance of green devel- ties that can be addressed only with a proac- opment. As President Hu Jintao remarked in tive government. a speech at the November 2011 Asian Pacific Second, there is advantage in being a rela- Economic Cooperation summit, China is tive latecomer. Because developed countries committed to “vigorously developing the industrialized following a high-carbon model, green economy.” This commitment is also their economies have to a great extent been evident in the Work Program to Control locked into a high-carbon path. On the other Greenhouse Gas Emissions during the 12th hand, China and other developing countries 240 china 2 0 3 0 TABLE 3.5 Comparisons of selected indicators for China and low-carbon technologies that face countries developed countries with less rapid growth and less rapid turn- over of capital stock. Indicator China United States Japan OECD Nevertheless, capitalizing on this advan- Per capita GDP (US$, 2011) 5,445 48,442 45,903 37,029 tage and leap-frogging certain technological Automobiles per 1,000 47 802 589 564 stages into the most efficient and greenest people (2009) options will require early strengthening of Per capita gasoline use 45 1,134 332 470 for road transport incentives. This is clearly shown in how rap- (kg. oil, 2009) idly China has overtaken the United States in Urbanization rate (%, 2011) 51 82 91 80 the efficiency of its coal-fired power plants Source: World Bank, World Development Indicators 2011. (figure 3.14). In the past 10 years, due to large-scale installations of larger and more efficient supercritical and ultra-supercritical can meet additional demand by building new power plants have led to a qualitative leap green productive capacity and infrastructure forward in the overall efficiency of China’s without having to eliminate equal amounts of coal-fired plants; those plants overtook the existing physical capital. China’s current level U.S. coal-fired plants in efficiency in 2005. of economic development is only one-eighth Third, a large domestic market allows to one-tenth the level of developed countries, China to scale up green sectors. China has measured in terms of per capita energy use, a vast domestic market that provides excel- car ownership, and other indicators (table lent conditions for the formation of industrial 3.5). Because China is still in a stage of rapid green sector supply chains, giving companies development, the incremental costs of green in China an advantage over competitors in development will be relatively low. China other countries in seizing “first-mover advan - can avoid the higher costs of transitioning to tages.” The rapid expansion of both wind power and solar photovoltaics (box 3.10), for instance, has shown that China is capable of achieving economies of scale with the sup- FIGur E 3.14 Efficiency and C o emissions of coal-fired plants in China and u nited States port of its large and growing domestic mar- ket. Large market size drives down produc- tion costs through learning by doing as well 37 1,100 as by lowering unit costs. Scale combined 1,080 with high investment levels and the abil- 1,060 ity to implement decisions quickly suggests 1,040 that opportunities can be exploited ahead of 1,020 competitors. 34 1,000 Fourth, abundant capital (including human capital) is available to invest in green sectors. China has traditionally enjoyed high rates of savings and investment (table 3.6); it attracts more direct foreign investment than any other country; it has built up an impressive research and development infra- structure; and it will have more than 200 million college graduates within the next 20 China CO emission intensity (right axis) years. Clearly, China possesses an abundant China eciency (left axis) amount of capital for green development that United States CO emission intensity (right axis) United States eciency (left axis) can be put to work, often with government support, to develop sunrise industries. The country is able to quickly acquire, adapt, and Source: Yuan and others 2011. Net thermal eciency (%) CO emission intensity (g/kWh) 2 Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 241 Box 3.10 China’s solar photovoltaic (PV) industry China is already the lowest-cost producer of solar companies producing silicon panels, more than 60 panels in the world, thanks in no small part to the companies making solar-powered batteries, and country’s large domestic market, which has allowed more than 330 companies producing components the solar industry to rapidly specialize and estab- for solar technologies. Fourteen Chinese solar com- lish an efficient division of labor. From equipment panies are already listed on foreign stock exchanges, manufacturing to the production of accessories and and 15 are listed on domestic stock exchanges. The auxiliary parts, the indigenization of the industry industry’s annual production value now exceeds has been especially fast. As part of the supply chain $45 billion, imports and exports have topped $22 for solar PV, by 2011, China already had 20 –30 billion, and the industry employs around 300,000 companies producing crystal silicon, more than 60 people. Source: Li and others 2011. TABLE 3.6 Comparative national investment, savings, and consumption rates Percent of GDP Saving rate Investment rate Consumption rate (%) (%) (%) Country 1970 2008 1960 2008 1960 2008 Average of developed countries 27 20 26 22 75 79 Average of Russian Federation and Eastern European countries 26 25 31 27 70 69 Average of South American countries 22 24 23 24 76 74 Average of Asian and African countries 23 34 19 29 61 47 China 27 54 36 44 61 47 Source: World Bank World Development Indicators 2010. master new technologies. Combined with the resources are also very high—almost two advantage of its large domestic market, Chi- times its power generation capacity 2005 na’s ability to attract foreign companies and (NDRC 2007). In addition, China’s current investors seeking to commercialize their own dependence on and large endowment of coal technologies brings additional know-how also provides an opportunity—in the form of and spillover effects. strong demand for cleaner coal, and the con- Fifth, China has an abundant natural tinuing dynamism of investment in the coal endowment of resources for clean energy. China’s natural endowments, such as wind, solar, biogas, and shale gas, favor new energy TABLE 3.7 Total exploitable renewable energy resources in China Gigawatts sources (table 3.7). The country’s theoretic solar energy reserves are equivalent to 1,700 Potential capacity based on resources (GW) billion tons of standard coal a year, and Wind power (on shore) 2,560 two-thirds of the country receives more than Wind power (off shore) 190 2,200 hours of annual sunshine. Compared Hydropower 542 with other countries at the same latitude, Solar photovoltaic 2,200 China’s solar energy resource is at par with Total 5,772 that of the United States and is much larger Source: Gao and Fan 2010. than that of Europe or Japan. China’s wind Note: Small-scale hydropower includes retrofits. 242 china 2 0 3 0 sector—for lower emissions coal technologies policy incentives change dramatically. An given the right policy support (Shi 2008). electricity-generation plant has a lifetime of Sixth, China has the potential to avoid 30– 40 years; its carbon footprint is fixed the lock-in effects of higher levels of urban- at the time it is built. Only if China adopts ization. Although China’s current level of green development policies sooner rather urbanization is low (47.5 percent) compared than later will it capture the lock-in benefits with high-income countries, that will change. of efficient buildings, cities, transport sys - During the 12th Five Year Plan period (2011– tems, and industries that use low-carbon, 15), the country is expected to invest $300 environmentally friendly technologies and billion in basic infrastructure. According to standards (figure 3.15). UN estimates, by 2030, about 65 percent of Conversely, high-carbon investments China’s people will live in cities (UN Popula- today will render it exceptionally difficult and tion Division 2009). expensive to achieve future emissions targets. The policy and investment choices made If negative lock-in effects occur, China will today and over the next two decades will have to either retire assets early, well before have long-lasting implications for efficiency, the end of their service lives, or purchase lifestyle, the environment, and carbon emis- emissions reductions elsewhere in the mar- sions. For example, if cities lack adequate ket. The incremental cost of going low car- public transit facilities, commuters have no bon now, by designing low-energy-intensive alternative but to resort to private vehicles. urban and transport structures, for example, As vehicle density increases, so does conges- is much less than the future cost to retrofit tion, which, in turn, sharply increases pollu- high-carbon cities to a lower carbon track. tion, including emissions of CO . Similarly, High-carbon power plants may not even be commercial and residential building design amenable to retrofitting. The prudent strat - will largely lock in energy needs for the life egy is to introduce forward-looking low-car- of the building, even if future price and other bon incentives now that lay the foundation FIGur E 3.15a What emissions growth path FIGur E 3.15b Which way will China’s transport should China’s cities take? sector efficiency evolve? 15 3 10 20 30 40 50 60 70 80 90 100 0 10,000 20,000 30,000 40,000 Urban share of total population, 2009, % GDP per capita, 2009 (US$, PPP) High emissions path Low emissions path Source: World Bank analysis based on IEA (2011a) and UN Population Source: World Bank analysis based on IEA World Energy Statistics Division (2009). and Balances, World Bank World Development Indicators. Note: Bubble size corresponds with total annual CO emissions. Note: Bubble size corresponds with total annual CO emissions. 2 2 United States Saudi Arabia Australia Canada United States Australia Japan Iran, Islamic Rep. Russian Federation France Korea, Rep. Spain South Germany Italy Africa Germany Korea, Rep. France Mexico China Brazil Argentina Mexico Japan India Turkey Chile India China Brazil Russian Federation South Africa tCO emitted per person, 2009 Emissions from road transport in 2009 (tCO /person ) 2 Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 243 FIGur E 3.16 Household water and wastewater for even stronger low-carbon policies in the tariffs in China’s 10 largest cities compared with future. The sheer speed and scale of China’s other major cities, 2008 urbanization and infrastructure construction lends urgency to this issue, as does the rapid expansion of the private automobile fleet. Copenhagen Seventh, China is becoming a major desti- Berlin nation for global investments and R&D. All Paris of the above advantages, coupled with China’s Singapore manufacturing capabilities, make it an excel- Melbourne lent location for investments in many global Los Angeles green technologies. Regardless of whether New York City future technologies are invented in China, Tokyo they will likely be commercialized there. The Saô Paulo cases of wind, solar, and cleaner coal technol- Toronto ogies are illustrative: the transfer rate of clean Osaka energy technologies from developed countries Jakarta to China is higher than to any other country Seoul or continent (OECD 2010). Since more than Hong Kong SAR, China 0.54 70 percent of China’s energy consumption Beijing comes from coal, there is a broad market Chongqing space in China for technologies to clean up Tianjin coal production and use. China can attract Shenzhen the world’s best green technologies. This will Guangzhou not only promote China’s own green transfor- Shanghai Wuhan mation but will also accelerate the develop- Dongguan ment of technical options available elsewhere. 0.27 Hangzhou Mumbai Factors Impeding Green Development 0 12 3456 7 8 9 China’s advantages that favor seizing US$ per cubic meter green growth opportunities notwithstand- ing, China also has to overcome a range of Source: Global Water Intelligence 2008. obstacles. First, prices of resource commodities are distorted. Because of market distortions and rigidities, the major factor markets of land, extremely low by developed-country stan- labor, and capital have encouraged capital-, dards (figure 3.16). For China to focus invest - land-, energy-, and pollution-intensive devel- ments and innovation in green industries and opment. As a consequence, damages to the technologies, it must pursue deep-reaching environment and public health associated policy and institutional reforms and estab- with the use of resource-intensive produc- lish markets in which prices reflect scarcity as tion technologies have not been included in well as social and environmental costs. production costs of companies; nor does the According to research by Huang (2010) supply and demand of these resources on the and others, undervaluing China’s labor, market reflect their true scarcity. Inefficient capital, land, energy, and environment is pricing mechanisms, such as for water and tantamount to offering subsidies to resource- land, is part of the cause, as are institutional intensive industries. For example, in 2009, weaknesses, such as the strong presence of subsidies embodied in artificially low energy monopolistic state-owned enterprises (SOEs). prices were equal to about 0.7 percent of For example, water tariffs in China are GDP. According to H. Li (2011), based on 244 china 2 0 3 0 will dramatically improve the competitiveness Box 3.11 International fossil fuel subsidies of solar power, wind power, and other forms of clean energy. Going further and including the social costs of pollution and illness asso- The International Energy Agency (IEA) estimates ciated with the burning of fossil fuels would that in 2010, fossil fuel consumption subsidies raise the price of fossil fuels even more. reached $409 billion. According to the IEA’s analy- Second, the country is overly reliant on sis, if subsidies can be gradually phased out by 2020, command and control measures for reduc- then global primary energy demand would decrease ing carbon emissions. Too much reliance 3.9 percent and CO emissions from energy by 4.6 on inflexible administrative measures has percent by that year, compared with a baseline in resulted in suboptimal allocation of resources which subsidies are unchanged. At their 2009 sum- for reducing carbon emissions and uneven mit in Pittsburgh, leaders of the Group of Twenty reached consensus on the need to gradually reduce compliance. The current provincial alloca- subsidies, while providing support to low-income tion of targets to reduce the energy intensity groups. “Inefficient fossil fuel subsidies encour- of economic output is an example. First, the age wasteful consumption, reducing our safety, targets are not allocated according to means obstructing investment in clean energies, and nega- or resources. During the 11th Five-Year Plan tively influencing measures to mitigate the dangers (2006–10), energy intensity targets for indi- of climate change,” the leaders said in a statement. vidual provinces were pegged to the national target of 20 percent. Although this method Source: IEA (2011b). seems to make sense, it has placed an overly heavy burden on the less-developed provinces that are currently experiencing a period of 2007 data, eliminating fossil fuel subsidies heavy industrialization. Second, although reduces China’s emissions by 6.21 billion tons targets for reducing energy or carbon inten- of CO . Similarly, Zheng and others (2011a, sity are the result of a negotiated political 2011b) predict that if electricity prices are not process, they are rigid (neither flexible nor raised, then by 2020, China’s urban residents tradable). This rigidity has increased the costs will use 10 times the electricity they do today; of compliance and made it more difficult and if water prices are not increased, then by for individual provinces to save energy and 2020, the average urban household will use reduce emissions, leading to such phenom- a multiple of current consumption. These ena as cutting off power (that is, resorting research results suggest that raising electric- to “energy poverty”) in order to meet targets ity and water prices for urban residents may that are even lower than what could other- be an effective policy tool. In Beijing, for wise be achieved. example, it is estimated that raising electricity Third, incentives for environmental pro- prices by just RMB 0.02 ($0.003) a kilowatt tection are weak. Clear environmental regu- hour will slow the average annual increase in lations enforced by government are crucial household electricity consumption from 35.6 for improving the quality of the environment. percent to 23.9 percent. Slightly raising the However, China’s environmental regulations water tariff in Beijing from RMB 3.70 ($0.57) remain relatively weak, and enforcement has a cubic meter to RMB 4.00 ($0.62) is pro- been inconsistent. jected to reduce the average annual increase The problems associated with a lack of in water use from 14.7 percent to 5 percent. incentives for environmental protection are The use of tiered pricing could prevent undue evident in both pollution monitoring and burden on low-income households. compliance and natural resource manage- The distortion of factor prices in China is ment. Of course, there are some successes a serious problem, but not one that is unique as well, often market based. In agriculture, to China. It is a global problem (box 3.11). the lack of longer-term property rights in Eliminating perverse subsidies for fossil fuels land and water has created a disincentive Seizing the Opp O r tunit y O f g reen De vel O p ment in c hina 245 to farmers to invest in longer-term sustain- have found it difficult to support long-term ability. Instead of increasing organic mat- public investments in projects that promote ter in their soil, for example, farmers find it environmental sustainability. In search of more economical to increase output in the revenue, many have grown excessively reli- short run by using more fertilizers and pes- ant on rents from land in peri-urban areas ticides. The same is true for China’s grass- that have been converted from farmland lands, many of which have been overgrazed and leased for development. As localities or encroached upon by expanding settle- have tried to attract outside investment and ments and are in decline. It was also true develop new industries to make up budget- for China’s forests, which, up until the late ary shortfalls, they have allowed projects that 1990s, experienced heavy cutting and were have damaged the environment and depleted shrinking. This situation was changed, how- natural resources. ever, largely through the introduction of eco- Finally, the lack of incentives for environ- compensation programs and reforms in for- mental protection is tied to the inadequacy est ownership. Between 2000 and 2009, the of the pollution control regulations that rely central government invested RMB 365 bil- on command and control directives, and to lion ($56 billion) on afforestation programs, the small scale of market-based pilot proj- providing cash payments and other incentives ects undertaken to date. For example, China for farmers who restored marginal lands in has attempted to establish local SO permit fragile watersheds, planted shelterbelts to trading schemes, modeled after the system in protect against sandstorms, and protected the United States. But these programs have natural forests. Reforms introduced in 2009 largely failed, because of overinvolvement by that extended the contract period for house- the government in trading that has weakened hold forest rights to 70 years and allowed the role of the market, led to the unfair allo- households to mortgage their rights strength- cation of permits, introduced problems in the ened the incentive for rural people to invest in design of trading mechanisms, and interfered sustaining forests. with monitoring of emissions. Similar to land, China’s water resources Fourth, a competitive market environ- management system lacks incentives to pro- ment for green industries is lacking. In real- mote efficiency at the scale required. As men - ity, China’s transition to green development tioned, the first obstacle to efficient water has two levels: the first is “greening” its cur - use is low tariffs. Other obstacles include the rent economic base, and the second is a more lagging water rights system reform and the fundamental shift toward emerging indus- inefficient use of market mechanisms. Some tries. Some Chinese green industries have examples are the extravagant use of water experienced rapid growth in recent years, for irrigation and the inefficient allocation of as exemplified by the rise of its clean energy water between different crops and regions. industries. Yet, its emerging industries still As a result, water for agriculture accounts lack a fair and open competitive market envi- for 65 percent of total water use, but only ronment in which to grow. 48 percent is actually used for crops (NBS The playing field for investment in emerg - 2010a; China Water Resources 2009). Only ing industries is still not level. In the case of 40 percent of industrial water was recycled the wind turbine and solar PV industries, for in China in 2003, compared with 75–85 per- example, private companies are mainly con- cent in developed countries (although indus- centrated in equipment manufacturing, while trial water recycling has been improving in SOEs continue to monopolize the electricity recent years). generation market (SERC 2011). State-owned China’s existing fiscal policies have dis- enterprises also dominate the development of couraged investment by local governments shale gas, which will continue to be noncom- in environmental protection. Because many petitive so long as the legal rights to shale gas local governments lack fiscal resources, they resources are not clearly defined (box 3.12). 246 china 2 0 3 0 Box 3.12 A lack of competition has held up China’s shale gas exploration China possesses abundant shale gas reserves with developing the resources but lack access rights. The an estimated 25 trillion–35 trillion cubic meters of result of this situation has been to hold up techno- recoverable resources, comparable to the 38 trillion logical innovation in the sector. cubic meters of conventional natural gas on hand. Extracting shale gas involves surveying, drilling, The country’s richest shale gas reserves tend to over- fracking, microseismic monitoring, environmental lap with areas in which state-owned oil companies monitoring, water treatment, and other advanced have registered conventional oil and gas fields. Under technologies. Exploiting shale gas resources requires current policies, these reserves can be explored only sustained, successive investments over a span of by existing state-owned oil companies. Yet, these many years. For that reason, it is particularly suited companies are mainly interested in conventional for exploration through coordinated investment by oil and gas resources and have made very lim- a diverse number of investors. For a single company ited investments in exploring shale gas resources. to develop a site from start to finish often puts great Some resources are claimed by companies but not strain on the investor and leads to low levels of effi - explored. In other cases, companies are interested in ciency and a lack of technological innovation. Sour