Working Paper No. 611 Why Has China Succeeded—And Why It Will Continue To Do So by Jesus Felipe Utsav Kumar Norio Usui Arnelyn Abdon Asian Development Bank, Manila, Philippines* August 2010 * This paper represents the views of the authors and not those of the Asian Development Bank, its executive directors, or the member countries they represent. We are grateful to Justin Lin and Ha-Joon Chang for their very useful comments; the usual disclaimer applies. Contacts: [email protected] (corresponding author); [email protected]; [email protected]; [email protected]. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2010 All rights reserved ABSTRACT The key factor underlying China’s fast development during the last 50 years is its ability to master and accumulate new and more complex capabilities, reflected in the increase in diversification and sophistication of its export basket. This accumulation was policy induced and not the result of the market, and began before 1979. Despite its many policy mistakes, if China had not proceeded this way, in all likelihood it would be a much poorer country today. During the last 50 years, China has acquired revealed comparative advantage in the export of both labor-intensive products (following its factor abundance) and sophisticated products, although the latter does not indicate that there was leapfrogging. Analysis of China’s current export opportunity set indicates that it is exceptionally well positioned (especially taking into account its income per capita) to continue learning and gaining revealed comparative advantage in the export of more sophisticated products. Given adequate policies, carefully thought-out and implemented reforms, and skillful management of constraints and risks, China has the potential to continue thriving. This does not mean, however, that high growth will continue indefinitely. Keywords: China; Capabilities; Diversification; Export-led Growth; Leapfrogging; Open Forest; Product Space; Sophistication JEL Classifications: O20, O25, O53 1 1. INTRODUCTION There is a vast literature trying to explain China’s very high GDP growth rate and poverty reduction since it started its transition to the market system in 1979.1 The three key stylized facts that underlie China’s high output growth rates are: first, its high growth rates of capital accumulation, driven by high investment-output ratios; second, a marked outward orientation through export-led growth policies (Felipe, Laviña, and Fan 2008); 2 and third, the pursuit of industrialization (in particular the production and export of manufactures), a key ingredient for fast growth and development (Rodrik 2006a). China’s miracle is that it has been able to sustain this process for three decades.3 In this paper we try to gain insight into China’s development by analyzing the evolution of its export basket since the 1960s, in particular how it has become more diversified and how it has shifted to products with higher income content. We argue that while reforms after 1979 were important because they opened the economy and provided incentives for the private sector to develop, they could not have succeeded without acknowledging the stock of capabilities that existed in the country. We show that as far back as the 1960s, China’s productive structure was quite complex already and this set the basis for the country’s future high growth. Reforms toward a market system since the 1980s have been a key in China’s development. However, we stress the path-dependent nature of development and emphasize the significant knowledge that had been accumulated before reforms started. The historical experience of the advanced economies and that of Asian countries such as South Korea indicates that development entails a shift from dependence on agricultural activities (especially on farming) into reliance on modern industrial and 1 Average GDP growth rate for 1960–2007 was 7.82%, and 6.21% in per capita terms. For 1980–2007, the rates were 9.93% and 8.74%, respectively. 2 Also, some growth accounting studies have documented that total factor productivity growth has been relatively high. On the contributions of factor accumulation and total factor productivity growth to overall growth, see, for example, Tsui, Hsueh, and Rawski (1995), Borensztein and Ostry (1996), Hu and Khan (1997), Young (2000), Felipe and McCombie (2002), Heytens and Zebregs (2003), Blanchard and Giavazzi (2005), and Islam, Dai, and Sakamoto (2006). Chow (1993) and Felipe and McCombie (2010) discuss the pre-reform period. 3 See the recent work by Storm and Naastepad (2005) and Lee and Mathews (2010). They emphasize different aspects of East Asia’s (China included) development, in particular the drive toward industrialization, the emphasis on capability building, export orientation, industrial targeting, and sequential upgrading. All of them are part of China’s story. 1 service sectors. This shift is referred to as structural transformation, and it is what leads to fast and sustained growth. In other words, becoming a developed country requires achieving sustained growth for a period of decades. In general, the only way to do this is through significant structural transformation.4 More precisely, structural transformation is the process by which countries change what they produce and how they do it, as well as how they move from low- productivity and low-wage activities, to high-productivity and high-wage activities. Structural transformation has three components: (i) shifts in the output structure, from activities of relatively low productivity into high-productivity activities; (ii) shifts in the employment structure, typically a decline in the share of employment in agriculture;5 and (iii) upgrading and diversification of the production and export baskets. It is not obvious how this process happens, except that in all successful cases, there has been some form of government intervention. In the case of China, this process did not start taking place on a major scale until after the Communist Revolution. 6 Along these lines, Hausmann, Hwang, and Rodik (2007), Hidalgo et al. (2007), Hidalgo (2009) and Hidalgo and Hausmann (2009) have argued recently that growth and development are the result of structural transformation, and, crucial in their story, show 4 This is a point forcefully emphasized by Chang (2009a) in his critique of some recent interpretations of development as poverty reduction. 5 The share of agriculture in total GDP has declined significantly, from about 60% during 1952–70, to slightly over 10% in recent years. However, agriculture is still the largest employer in the economy (still over 40% of total employment). Felipe (2009: 150–151) concludes that most of the growth in overall labor productivity in China during 1987–2002 was due to the growth in labor productivity within industry. The contributions of labor productivity growth within agriculture and within services were minimal. Likewise, the contribution of labor relocation from agriculture into industry to overall labor productivity growth was negative due to the decline in the employment share in industry during this period, while the contribution of labor relocation from agriculture into services was significant due to the large increase in the share of employment in services. Overall, the growth in labor productivity in industry plus the effect of relocation of labor from agriculture into services accounts for over 80% of overall labor productivity growth during said period. 6 Ward (1962) notes that despite China’s great knowledge (e.g., printing and gunpowder were invented far ahead of the West), the break-through (i.e., modern take-off as a result of the application of science to economic processes), never came. She argues that “the Confucian gentleman who dominated the official thinking of Chinese society thought science an occupation for charlatans and fools and, therefore, not really respectable […] They (the Confucians) turned their backs on experiment and, in doing so, on science as well. So in China, for ancient glory of its culture, for all the force and vitality of its intellectual tradition, the scientific break-through could not occur” (Ward 1962: 48–49). 2 that not all products carry the same consequences for a country’s development.7 The reality is that developing countries face serious problems when they try to become competitive in a new product, when they try to enter a new market, and when they try to shift production and exports toward more sophisticated products. Hausmann, Hwang, and Rodik (2007) show that the specific set of products that a country exports has important consequences for the pattern of development. Empirically, a measure of the sophistication of a country’s export basket proves to be a good predictor of future growth: controlling for initial income, countries with a more sophisticated export basket (also initially) grow faster. On these grounds, Hidalgo et al. (2007) argue that development has to be understood as the process of accumulating more complex sets of capabilities and of finding paths that create incentives for those capabilities to be accumulated and used. The implication is that a growth miracle sustained for several decades must involve the continual introduction of new goods, not merely continual learning on a fixed set of goods. To analyze development and structural transformation from this perspective, Hidalgo et al. (2007) have developed a new analytical tool called the product space.