4 Industrial Structural Upgrading and Poverty Reduction in China Justin Yifu Lin1 and Miaojie Yu2 4.1 Introduction In the three decades of economic reforms since 1979, China has successfully maintained a 9.9% annual gross domestic product (GDP) growth rate and registered a 16.3% annual growth rate for international trade (Lin, 2010). China has already taken over Japan as the second largest economy in the world, and it will become the largest economy by the 2020s in terms of purchasing power parity.3. Even if China was negatively affected by the recent global financial crisis, China still surpassed Germany as the largest exporter in the world in 2009, and it is currently recognized as the largest “world factory.” China has also succeeded in reducing poverty. In 1979, China was one of the poorest agrarian countries in the world, with a per-capita annual income of US$243 at 1979’s exchange rates4, which was about one- third of the average in Sub-Saharan countries. After only three decades, China’s per-capita GDP increased to approximately $5,000 in 2011, and China became an upper-middle income country, according to the classification of the World Bank. China’s rapid growth was achieved through a dramatic structural transformation, which can be observed from changes in the sectoral composition of GDP. In 1978, primary goods accounted for 28.2% of GDP, and agricultural exports for around 35% of China’s entire exports. In sharp contrast, the proportion of primary industry in China’s GDP today has shrunk to 11%, and agricultural exports only account for less than 3.5% of China’s total exports. With the declining share of agricultural goods, manufacturing exports have increased dramatically in the last three decades, increasing from 65% in 1980 to approximately 96.5% in 2009 (Yu, 2011a). Similar changes occurred in the composition of employment. The share of the labor force in primary industry declined from 70.5 percent in 1978 to 38.1 in 2009 whereas the labor force in secondary industry increased from 17.3 percent to 27.8 percent in the same period. Industrial upgrading is also a remarkable feature of China’s economy since its economic reform. As discussed later, China’s industrial upgrading exhibits four clear phases. In the first phase (1978 to 1985), China still relied on producing and exporting resource-based goods, such as oil and gasoline. The second phase (1986 to 1995) witnessed a fast growth of 1 Professor of CCER, Peking University, and Former Chief Economist in the World Bank. Email: [email protected] 2 Professor of CCER, Peking University. Email: [email protected]. 3Some research, such as Feenstra et al. (2011), even predicts that China will surpass the US in 2013 using real- price adjusted purchasing power parity. 4Sources: China’s Statistical Yearbook (2011), Author’s calculation. 1 labor-intensive exports. In the third phase (1996 to 2000), the main export from China was electrical machinery and transport equipment. At the same time, China also imported a large volume of machinery. The increasingly important role of intra-industry trade can mainly be attributed to China’s successful industrial upgrading and the prevalent processing trade that aligned production with China’s comparative advantage. The latest phase, which began in 2001, has recorded a fast export growth in high-technology products, such as life-science equipment. China’s successful structural transformation and industrial upgrading beg the question of how it developed from a backward, closed, and agrarian economy to an open, competitive world factory. In this chapter we will discuss what happened to China’s production structure and industrial upgrading. How did China successfully upgrade its manufacturing structure in the last three decades? What are the fundamental driving forces behind the transformation? Furthermore, to what extent did the rapid structural transformation and industrial upgrading help to foster employment and reduce poverty in China? Finally, what lessons can be learned from China’s successful structural transformation and industrial upgrading? Our basic argument is that China’s rapid industrial upgrading and its consequent poverty reduction are mainly attributed to the adoption of an appropriate development strategy, which is a comparative-advantage-following (CAF) development strategy, driven by its factor endowments (Lin, 2003, 2009, 2012, Lin, et al., 2004). As China is a labor abundant country, the labor-intensive industries can be competitive and viable if the market is not distorted. The latent comparative advantage of the Chinese economy was suppressed before its economic reform because China’s government adopted a heavy industry-oriented development strategy. As such the development strategy was comparative-advantage- defying, China’s government set up an organic but deeply distorted system to support economic development with priority on heavy industries. Under this system, the prices of input factors and output were set by a planned administration system and were hence distorted. Firms were deprived of production autonomy and lacked incentives. Efficiency was low. Accordingly, the industrial structure could not be upgraded. As heavy industries are capital intensive and incapable of absorbing more labour, employment opportunities in the industrial sector were limited in spite of large investment. Finally, as the state required its puppet-like state-owned enterprises (SOEs) to squeeze as much profit as possible out of production, wages for workers were suppressed at a low level, and the prices of agricultural products were set with unfavorable terms of trade against peasants. Both forces made the Chinese people maintain a low living standard, and severe poverty could not be alleviated. After its economic take-off, China adopted a CAF development strategy. The two main aspects of this strategy are both the adoption of the dual-track reform to provide temporary protection or subsidies to the traditional and old sectors and the encouragement to develop new viable sectors aligned with its comparative advantage driven by its factor endowments. The dual-track reforms, including price reform of output and input factor markets as well as foreign trade and exchange rate reforms, were essentially Pareto optimal. All reforms started by allowing the existence of two tracks, that is, one dominated by the state and the other 2 oriented to the market. The two tracks subsequently converged and unified to a market track only. Similarly, to avoid the collapse of SOEs due to the shock of rapid reform, SOE reform began with granting management autonomy and then moved to institutional transitions. More importantly, new firms and industries aligned with China’s comparative advantage were greatly encouraged. The growth of China’s town village enterprises (TVEs) serves as an excellent example. The government’s successful growth identification and facilitation played a vital role in transforming its economic structures and upgrading its manufacturing structures because they overcame asymmetric information, coordination failure, and even externality appropriateness that are associated with market mechanism (Lin, 2012). The structural transformation and industrial upgrading also have significant effects on employment generation and poverty reduction. With structural transformation, the share of the primary sector in GDP declined dramatically, and the shares of the secondary sector and, especially, the tertiary sector consequently increased. As a result, laborers moved out of the primary sector and earned higher wages in the secondary and tertiary sectors. With the correction of the distortion in input factors, the unfavorable terms of trade against the peasants were redressed. The boom of TVEs also provided more employment opportunities for rural people with high-income earnings. The government’s forceful facilitation in the rural area also improved both hard and soft infrastructures. The three factors mentioned above improved the living standard and dramatically reduced poverty in the rural area. The industrial upgrading also improved the living standards of workers in the urban area. With a CAF development strategy, labor-intensive industries developed rapidly, which in turn created new working opportunities. After three decades of reforms, SOEs were downsized in terms of numbers and output, but their performance was in a much better shape after efficiency increased and workers’ initiatives were stimulated. As a result, workers’ living standards were improved in the urban area, along with structural transformation and industrial upgrading. Other developing countries can learn two main points from China’s economic miracle. First, to upgrade industrial structure successfully, a developing country must adopt a CAF development strategy based on its factor endowment. Second, despite a free, fair, and competitive market mechanism, governments of developing countries are suggested to play a proactive role in facilitating structural transformation and industrial upgrading. A useful framework for growth identification and facilitation with several key suggestions is provided and discussed in this study, as policy makers usually find identifying growth opportunities difficult. The remainder of this chapter is organized as follows. Section 2 introduces the conditions faced by China’s manufacturing industry before China’s economic reform in 1978. Section 3 discusses the trends and characteristics of China’s industrialization and manufacturing