By Linda Yueh.

As the new Chinese leadership takes over, their biggest economic challenge remains generating growth for another 30 years. In addition to re-balancing the economy and stimulating more productivity, a key aspect will be the re-defining the role of the state. After over 30 years of marketisation and reform, China remains a mixed picture of state-led policies and a growing number of facially neutral laws with some exemptions for state-owned enterprises. In addition, the state-owned commercial banks continue to benefit from official “financial repression” policies, such as the preservation of a spread between lending rates and deposit rates. It helps to generate margins for banks and facilitate their recapitalisation. This policy also enables the state-owned commercial banks to continue to support government policies ranging from fiscal stimulus to supporting state-owned enterprises, though not without cost to overall economic growth as financial repression distorts the allocation of capital.

The high levels of capital formation (some 40% of GDP) in the past two decades and the inefficient allocation of capital away from more productive private firms are worrying. The Twelfth Five Year Plan (2011-15) plans to re-balance the economy towards greater domestic demand and less of a reliance on exports. A key part of the plan is to increase consumption and other parts such as more urbanization and services development would support investment in developing larger urban areas where migrants can settle and government services can be dispersed more efficiently.

This plan in actuality has an implicit 30 year time horizon as these policies of migration, urban development and boosting consumption cannot be achieved in a short time period. Unless China can re-orient its growth model including towards more efficient investments by private firms, then it could find it difficult to sustain a strong growth rate. Part of this challenge will include creating a more secure welfare state.

Government expenditure as share of GDP, 2000-10

Source: IMF, World Economic Outlook, April 2011. Note: ASEAN-5 refers to Malaysia, Indonesia, Thailand, the Philippines and Singapore.

Curiously, the Chinese state comprises a comparatively small proportion of GDP as these figures only measure government expenditure and not its ownership of state-owned enterprises. Therefore, though the state owned nearly all of the modes of production in 1978, government spending has averaged 14 percent of GDP since then. It had not exceeded 17 percent until the global recession of 2008/9 when government spending increased by over four percentage points of GDP to make up for the collapse in exports. Even then, government’s share of GDP was only around 23 percent. Compared with other major and developing countries, China has the lowest average share of government in GDP than all major country groupings, including other parts of developing Asia, Africa, and comes in at half of Eastern Europe.

There is a large literature on the optimal size of government which tends to find an inverted-U relationship between the share of government spending and GDP growth (see e.g., Barro 1990). It is, though, the efficiency and the nature of the government spending that matters more for growth than size. From 1960-1992, Levine and Renelt (1992) find that government consumption as a share of GDP averaged 16 percent for fast-growing economies while it was 12 percent for lagging economies. But, they didn’t find a significant impact on economic growth from an increase in government consumption. Rather, government spending that facilitates productive investment, which can include education, health, seem to have a more significant impact. Tanzi and Schuknecht (1997) find that social spending has increased significantly in the OECD since 1960, but the positive growth effects diminish after government spending reached between 30-40 percent of GDP.

There is no stated goal to increase the government’s share of GDP in China, despite the efforts in the Twelfth Five Year Plan to support domestic consumption through reducing the savings motive through increasing social service provision. But, there is an aim to increase the share of the services sector, which would encompass greater government delivery of services. The service sector comprises about 40 percent of GDP and held that share throughout the 2000s, which meant that the goal of raising it to 43 percent by the end of the Eleventh Five Year Plan in 2010 was missed.

The services sector increased steadily as a share of GDP from 23 percent in 1979 to 40 percent in the 2000s but has not developed further, leading China to have a lower share of services in GDP than comparable-sized economies where the services sector account for well over two-thirds of GDP. Services is a non-tradable sector as it includes items such as haircuts and government services that would help to increase both domestic demand and reduce savings if such service provision included the delivery of social security. As such, government spending on services can reduce the savings rate of the economy while boosting domestic demand and incomes. Urbanization further allows the delivery of services to be distributed more efficiently such that there can be greater economies of scale. For instance, health, pensions, unemployment, local services, and schools can all be developed as part of the services sector with the infrastructure needs to support this development, which increases the efficiency of investment and associated industrialization in the urban area. And, government spending on services could reduce the precautionary motives for household savings.

Therefore, there is a need for the state to retain its presence in the economy, but it is the nature and scope of its activities that need to change. In particular, increasing social spending and public investment that can aid productive private investment to establish more of a social welfare system can aid growth. There is no particular inclination in the Twelfth Five Year Plan or any other previous plans to move towards a more Western model of a welfare state as found in Europe. But, there is a recognition that domestic consumption must be increased which requires addressing the savings motive of households that is related to the inadequate social welfare system. As with all Chinese reforms, there is no explicit goal, but the state acts on the pragmatic need to address a high savings rate that is hampering the re-balancing of the economy.

In conclusion, the reach of the state in China has receded in overt ways, but remains pervasive in other respects. State dominance has faded with the privatisation reforms of the 1980s and 1990s, but the cessation of that trend in the 2000s points to a state that will remain active in the market. For instance, the retention of large state-owned enterprises and the continued control of state-owned commercial banks point to continued state ownership. Moreover, it is not in terms of explicit state ownership that defines the borders of the Chinese state. In less overt ways, laws and policies to further the development of the market have not always created a level playing field. The “financial repression” in the banking sector of directing China’s large pool of savings towards state-owned enterprises and government policies and the use of foreign exchange reserves to fund Chinese state-owned enterprises “going global” are all implicit ways of maintaining state influence in the market. These policies are geared at supporting China’s continued economic development and transition, but would still generate distortions and are not without some economic cost to the private sector and to the economy as a whole.

For China to grow well for another 30 years will, though, require further reforms to improve the playing field for both its and foreign firms. Continued reforms of factor markets (capital, labour) as well as re-balancing its economy are also necessary. The impressive track record of the first 30 years of nearly 10 per cent growth every year won’t be repeated. But, China can grow on a more sustainable basis and continue to increase the standards of living of its people. It will need to focus on the growth drivers for the next stage of its development, which includes not just the restructuring of the economy, but pursuit of technological progress and innovation. The evidence looks promising on many fronts, but challenges also lie ahead. If China can pursue both structural and productivity driven reforms, the future of the world’s most populous nation will continue to be bright and continue to contribute to global growth as its second largest economy and emerging superpower.

Linda Yueh is a Fellow of Economics at the University of Oxford. This post is adapted from her new book China’s Growth: The Making of an Economic Superpower (Oxford University Press April 2013).