China's pattern of growth : moving to sustainability and reducing inequality

41854 WORLD BANK CHINA OFFICE RESEARCH WORKING PAPER NO. 2 CHINA'S PATTERN OF GROWTH: MOVING TO SUSTAINABILITY AND REDUCING INEQUALITY by Louis Kuijs and Tao Wang 1/ 2/ Abstract This paper studies the sources and pattern of China's impressive economic growth over the last 25 years, and shows that key issues currently of concern to policymakers--widening inequality, rural poverty, and resource intensity--are to a large extent rooted in China's growth strategy, and resolving them requires a rebalancing of policies. Using both macro level and sectoral data and analyses, the paper extends the growth accounting framework to decompose the sources of labor productivity growth. We find that growth of industrial production, led by a massive investment effort that boosted the capital/labor ratio, has been the single most important factor driving GDP and overall labor productivity growth since the early 1990s. The shift of labor from low- productivity agriculture has been limited, and, hence, contributed only marginally to overall labor productivity growth. The productivity gap between agriculture and the rest of the economy has continued to widen, leading to increased rural-urban income inequality. Looking ahead, we calibrate two alternative scenarios. We show that continuing with the current growth pattern would further increase already high investment and saving needs to unsustainable levels, lower urban employment growth ,and widen the rural-urban income gap. On the other hand, reducing subsidies to industry and investment, encouraging the development of the services industry, and reducing barriers to labor mobility would result in a more balanced growth with an investment-to- GDP ratio that is consistent with the medium-term saving trend, faster growth in urban employment, and a substantial reduction in the income gap between rural and urban residents. Keywords: Sources of growth; pattern of growth; labor productivity; labor relocation; income inequality; sustainability of growth; China. World Bank China Research Paper, No. 2, October 2005 1/ World Bank, Beijing Office. Email: akuijs@worldbank.org 2/ International Monetary Fund. Email: taowanghome@yahoo.com Acknowledgements: We thank Bert Hofman for encouragement and comments. We also thank the participants of the Chongqing Conference of the China Economist Society in June 2005 for their comments. The World Bank China Research Paper series disseminates the findings of research on China to encourage discussion and solicit feedback. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in these papers are those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries it represents. The findings, interpretations, and conclusions expressed in this paper also do not represent the view of the International Monetary Fund, its Executive Directors, or the countries it represents 1  1. INTRODUCTION China's GDP growth has averaged 9.4 percent per annum since 1978. As a result of this impressive growth, millions of people were lifted out of poverty. Economic reforms implemented over the last 25 years have certainly been instrumental to the remarkable growth performance, leading to higher productivity growth than in the pre-reform period. Nevertheless, it is widely agreed that China's growth during this period has been resource intensive, drawing heavily on physical capital, energy, and natural resources. In recent years, growth has also been associated with rising inequality. As China increasingly faces a widening rural-urban income divide and heavy demands on energy, water and other natural resources, and with savings expected to decline in the medium term, concerns are growing about the quality and sustainability of China's growth. In this paper we: (1) identify some key features about the growth experience; (2) demonstrate the link between the pattern of growth and the effect on urban employment and income distribution; and (3) present two scenarios to answer the following questions: how sustainable is the current type of growth, and what kind of policy adjustment are necessary to achieve the government's goals of urban employment growth and reduction of inequality? 2. KEY FEATURES OF CHINA'S GROWTH 2.1 Sources of Growth: Capital, Labor, and Total Factor Productivity A number of studies have used growth accounting to analyze the sources underlying China's growth of the past 25 years. These studies assume a certain production technology and try to assess to what extent factor accumulation and total factor productivity (TFP) contributed to growth (see Heytens and Zebregs (2003) for a summary). While estimates differ due to variations in assumptions, the studies have converged on a number of findings. TFP growth contributed significantly to GDP growth, having increased since the introduction of reforms in the end-1970s. Estimates of TFP growth during the reform period range between 2 and 4 percent per year. These studies also find that the contribution of physical capital accumulation has been large, reflecting a high and increasing investment to GDP ratio. Consistent with slowing overall employment growth, the contribution of labor growth has been modest, especially over the last decade. Our own growth accounting exercise for the 1978-2004 period finds similar results. We assume Cobb-Douglas technology, and a capital-output ratio of 2.4 in 1978 (as in Wang and Yao (2002), Chow (1993), and Hu and Khan (1997)), depreciation of 5 percent per year (as in Wang and Yao (2002)), and an elasticity of output with respect to labor of 0.5. We estimate that growth in the capital stock, which has averaged 10 percent per year, has contributed to more than half of GDP growth; TFP growth, at 3.3 percent per annum, contributed another one-third; employment growth contributed the modest remainder. Moreover, splitting the sample into two periods, we find that, between 1993 and 2004, the contribution of capital accumulation to GDP growth was even higher, at 62 percent, while TFP growth slowed somewhat to 2.7 percent per year, contributing about 30 percent of GDP growth. Total employment growth has been very modest, accounting for only 6 percent of GDP growth. Meanwhile, the capital-output ratio is estimated to have risen from 2.2 in 1994 to 2.8 in 2004, reflecting the rapid investment growth in the last decade. An alternative way of looking at these trends is to decompose labor productivity growth. Using the relationships from the Cobb-Douglass production function underlying the growth accounting 2  exercise, we can decompose labor productivity growth into TFP growth and a term related to the increase in capital-intensity (the increase in the capital-labor ratio). Equation (1) is the standard Cobb-Douglass production function: Y=ALK1- (1) where Y is real GDP, A is total factor productivity (TFP), L is employment, and K is the capital stock (in constant prices). From this equation, we derive the expression for labor productivity: Y/L = A(K/L) 1- or y = Ak1- (2) where y= Y/L, and k = K/L. From equation (2), the change in labor productivity over time can then be written as (y)/t = k1- A/t + A(1-)k- (k)/t (3) Labor productivity growth can then be written as: (y)/t/y = k1- y A/t+ A(1-)k- y k/t -1