The OECD has recently published a lengthy study on the Chinese economy, analysing the problems impeding economic development. In this extract from the synopsis, the organisation suggests ways to raise labour utilisation, foster innovation and improve business productivity.
China’s economy is clearly operating below its productive potential. Human, capital, land and other resources are under-employed, misallocated among economic sectors and inefficiently used. Achieving better resource utilisation is the most basic challenge China faces in seeking to meet its development objectives.
Better integration among the various segments of China’s economy is likely to be essential if resource utilisation is to be improved. Many of the priorities and suggested steps outlined below will need to be supported by complementary policies to improve market framework conditions and to strengthen the capacity of the government to support economic development.
The task of achieving full employment in China is daunting. Rough projections indicate that China’s aggregate labour force will increase by more than 70m over the next decade. To absorb these new entrants, along with the millions of workers expected to leave agriculture, while making progress towards reducing the number of underemployed, will require substantially more rapid employment growth in industry and services than in recent years.
Given the widespread structural distortions in the economy, macroeconomic policy, although it has an important complementary role to play, can do little in the medium-term if inflation is to be contained. Instead, achieving better labour utilisation is fundamentally structural challenge. Labour market reforms are a necessary pre-condition to achieve this goal, but broader reforms will also be required.
National labour market
The key priority for improving the capacity of labour markets is to overcome an inherited pattern of labour market segmentation and establish a national labour market. This is necessary because, whatever purposes they may have served in the past, impediments to rural-urban migration and other impediments to mobility have become major obstacles to absorption of excess labour and improvement in labour productivity. Removal of labour mobility constraints is necessary not only to allow workers to find jobs but also to reduce other distortions.
In particular, access to a wider array of jobs should improve incentives for rural workers. Increasing the supply of labour to urban areas should stimulate development of urban businesses. Integrated labour markets should foster business location to areas offering the greatest comparative advantages in terms of access to resources, suppliers and markets.
An essential step towards creating a national labour market is to begin to phase out the constraints on migration to urban areas and other barriers to the recruitment of non-local workers by urban enterprises.
Reform of the household registration system (hukou) is necessary to reduce these impediments, and this has recently been endorsed in principle by the Chinese authorities. Several local experiments with its relaxation are under way. The step has broader implications that condition its timing: in particular, the phase-out might begin with medium- sized cities followed by larger cities.
Furthermore, to genuinely improve labour mobility and integration, hukou relaxation needs to be accompanied by reforms of the rural land tenure system if rural migrants are not to face a prohibitively large loss of their land assets. Reform of land tenure, whose terms vary widely, is also necessary to ensure that migration incentives are similar across regions.
While a key step, elimination of hukourelated constraints on rural-urban migration and land tenure reform are only first steps. Other complementary measures need to be taken, beginning with improved labour market flexibility.
Local preferences and other measures within and between urban areas that inhibit migrants from seeking education or finding jobs in the formal sector also need to be eliminated in a timely fashion. Development of the unemployment insurance system to replace the transition arrangements being used to help laid-off SOE workers should help to improve incentives for efficient jobsearch. OECD experience suggests that unemployment insurance reforms can be reinforced through the establishment of a modern employment service that works with businesses to improve collection and dissemination of information – but which does not seek to interfere with hiring decisions.
Over a longer period, development of SMEs in or near cities in interior provinces needs to be fostered, along with the expansion of existing cities and creation of new cities in areas where they are economically viable. This will be necessary to ensure that rural migrants from these provinces can find jobs without a mass exodus to coastal cities, and the attendant excessive congestion that such an exodus would likely create.
Improved labour market performance also depends on broader social reforms. Achieving higher educational standards is a key priority in this regard, particularly in rural areas where education expenditures and attainment lag behind those in urban areas considerably. A longer-term goal suggested by OECD experience would be to raise the average duration of formal education from the current 9-10 years to 12 years, and to increase to 25 per cent the proportion of students that are educated up to 16 years of age.
Reform of social benefits
Better integration of the markets also depends on reforms to increase the coverage and portability of pensions and other social benefits. While achievement of these objectives is necessarily a longer-term goal, more attention needs to be paid in the medium term to relieving distortions that arise from the unevenness in financing burdens for the government- run first tier of the pension system. These distortions are greatest between rural and urban enterprises, and between the informal and formal sectors within the urban sector, and are due to the currently limited and uneven coverage of pension benefits.
These differences have worsened as required contribution rates for enterprises subject to the formal pension system have increased. A first step would be to reduce disparities that now exist among urban areas, possibly by pooling financing of the first tier of the pension system at the provincial government level, rather than at the municipal level as is now the case. Over the longerterm, coverage will need to be extended to rural workers and those now in the informal sector in cities, but with flexibility to allow extersome local variations in contribution and benefit rates.
Labour market reforms can improve the conditions under which labour is supplied but improvement in the capacity of the business sector to p r o d u c t i v e l y employ both labour and capital is equally crucial. An important longerterm goal is to foster the development of China’s service sectors, particularly labour-intensive services, but the pace at which this occurs will depend on further increases in urbanisation.
The more immediate priority is to restructure China’s industrial enterprises through consolidation and reorganisation to achieve a more efficient structure of industry as a whole. Technology also needs to be upgraded and industry’s capacity to innovate and to absorb new technology strengthened.
China’s government has long been heavily and directly involved in industry restructuring. Since the 1980s, authorities have sought to develop large enterprises as ‘national champions’ to compete in international markets with multinational corporations – although these efforts have met with little success. More recently, the government has intervened extensively and directly to reduce excess labour and other policy burdens of SOEs, to lower surplus capacity and to manage SOE restructuring.
While these efforts have had important benefits, they have also distorted the restructuring process, for example by requiring stronger enterprises to merge with weaker firms. Much of the government involvement reflects its continued intervention in SOE management. Government efforts have also been focused on large SOEs destined to remain under state control.
Role of market mechanisms
A key message of the study is that market mechanisms need to be strengthened so that they play the dominant role in China’s business restructuring. Fundamental improvement in the performance of China’s industries will involve extensive reallocation of resources, and changes in ownership and control extending across thousands of enterprises in both the state and non-state sectors. SMEs are crucial to this effort and their importance will further increase as the economy shifts toward more labour-intensive activities.
These changes will need to come about primarily through market-driven processes in which individual enterprises reorganise to maximise the long-term value of their operations. While trade and investment liberalisation offers opportunities to large Chinese enterprises, success in international markets has come to depend less on the scale of a multinational’s operations than on the sophistication of its management and the effectiveness of its governance – qualities over which government can have little direct control. Given these conditions, government policies to promote restructuring need to focus on establishing conditions that support market restructuring processes, such as improving competition and clarifying property rights, while limiting direct interventions to matters such as the disposition of SOE assets, where market processes alone are insufficient to accomplish the task.
The most pressing need is to remove obstacles that now exist to market-driven business restructuring. Two sets of policies are most essential to accomplish this objective. The first is financial system reform. It will not be possible to shift resources towards enterprises that can use them most efficiently unless credit allocation is much more firmly based on strict commercial criteria than is now the case.
For this to happen, banks and other financial institutions will need to have greater capacity and better incentives to lend to productive outlets. Financial markets need to be more flexible and open if they are to facilitate transfers of ownership and create a market for corporate control. OECD experience also offers lessons for improving access to extersome nal financing for creditworthy SMEs, as part of broader efforts to develop this key enterprise segment.
The second key step is to end government interventions that constrain enterprises’ ability to reorganise, distort their incentives to do so, and which block their exit when needed. SOEs need to be given autonomy to choose the partners and terms for mergers and acquisitions, without being burdened by non-commercial requirements imposed by government authorities. SOEs also need to have clearer claims and control over their assets if they are to be able to restructure their operations in a productive manner. Regional barriers to capital mobility and to cross-provincial business location also need to be curtailed.
Policies that have the effect of creating cartels or price floors should be avoided wherever possible since these tend to limit incentives for restructuring and to slow exit. Equally important are reforms to facilitate and accelerate exit, since large numbers of China’s present enterprises are not competitively viable and will need to leave the market if industry is to become more efficient.
While such measures are essential first steps, their ultimate payoff depends on reforms in other areas. These include measures to eliminate external conditions that would tend to distort restructuring decisions, such as unequal social benefit burdens and incentives that encourage regional protectionism. Equally important are reforms to corporate governance and other framework conditions that are needed to ensure that enterprises have the capacity and incentives to exploit restructuring opportunities. Authorities might also review the current policy of developing national champions and consider narrowing its focus to areas where China’s current advantages give it a better chance of success than in the past.
The technology challenges facing Chinese industry further underscore the importance of strengthening market forces while improving the quality of government intervention. Meeting these challenges involves more than simply making more technology available to the market. Other key objectives are to foster the improvement of capacities at the firm level to innovate and to use and absorb technology; to improve technology diffusion; and to enhance the technological pay-off from foreign direct investment.
Explicit technology policies cannot achieve these objectives by themselves without broader reforms. In particular, bolstering firm abilities and incentives to keep up with market technology standards requires improvements in management and governance, competition, and other framework conditions necessary to ensure that firms are adequately profit-oriented.
Equally important are reforms to improve protection for intellectual property rights to encourage technology sharing and the development of venture capital facilities. Further opening of knowledge-based service sectors to foreign participation would also help to foster technology transfer from abroad.
The government has an important role to play in improving China’s technological capabilities but there needs to be a change in emphasis. The government is likely to have to supply much of the resources to bring funding for basic science up to levels closer to international norms. China’s government can contribute to technology diffusion by providing support to regional university and other research centres, for example.
There is also a need to embed government technology policies in a broader framework that exploits complementary relations with other industrial policies. This is likely to require greater co-ordination between the Ministry of Science and Technology, which has been largely responsible for technology policy, and other ministries.
Despite its impressive performance, there is significant room to improve China’s foreign direct investment performance. The strengthening of intellectual property rights protection under China’s accession agreement should help to attract more foreign direct investment from business in developed countries, which have sometimes been reluctant to invest in the domestic market out of concern that their advanced technologies and production techniques will be inadequately protected.
Establishment of market-based mechanisms for domestic M&A would also help to attract investment from more advanced economies. Adoption and effective enforcement of a comprehensive competition law, and reduction in administrative and other barriers beyond those required by the WTO, would encourage more foreign investment aimed at the domestic market. Further opening of protected industries, for example by allowing more foreign participation in extractive activities, would also help to attract foreign direct investment, as well as increase efficiency.
Other measures could help to improve the pay-off to the domestic economy from foreign investment. Improved competition and better enforcement of contracts would encourage more local sourcing of inputs, such as packaging materials, used by resident foreign enterprises. Reduction of government interference in the operations of domestic enterprises could help to foster more fruitful partnerships with foreign firms possessing advanced technology.
China in the World Economy: The Domestic Policy Challenges-Synthesis Report. . OECD, 2002. Synthesis of the main findings and policy recommendations of the study China in the World Economy: The Domestic Policy Challenges, 2002. More information on these publications can be found in the OECD website:www.oecd.org
First commercial flights to India
The first direct flights between China and India started in late March. China Eastern Airlines is now operating a twice-weekly service from Shanghai to Delhi via Beijing. Meanwhile, China Southern Airlines has increased the frequency of two of its services from Guangzhou. China’s largest carrier now operates daily services to Tokyo and Ho Chi Minh City in Vietnam.
Safety checks ordered following crash
The Civil Aviation Administration of China ordered Chinese airlines to carry out urgent safety checks following the crash of an Air China passenger jet in South Korea on April 15 that killed 122 passengers and crew. The 17-year-old Boeing 767-200 crashed into a mountain as it was approaching Busan airport in heavy rain and fog. An investigation is under way.
This was the first fatal accident involving Air China since it was established in 1988. The company is planning to list shares in New York and Hong Kong, probably next year, and it is also looking for a strategic investor as part of that listing.
Second airport planned for Beijing
Beijing is planning to build a second airport in addition to a new terminal and runway that are already being planned for the existing airport, reported People’s Daily. The head of the Beijing airport company, Li Peiying, said that a committee had been set up to decide on the best location for a second airport. However, he added that Beijing’s existing airport facilities would have to be fully utilised before construction on a second airport began.
Zhongda to buy more cruise liners
The Shenzhen-based property developer and tourism company Zhongda Group is to buy two more luxury cruise ships and a yacht club, reported South China Morning Post. The company already owns a luxury cruise ship capable of carrying 400 passengers that offers overnight return voyages from Hong Kong’s Victoria Harbour to Shekou in Shenzhen. The two new cruise liners, to be imported from Germany, will be able to accommodate 1,000 passengers. The company said it is targeting businessmen and government officials.
Star Cruises Ltd, the biggest cruise line operator in Asia, is also expanding its China services. The Malaysia-based company plans to build two new cruise liners at a cost of US$350m each and to initiate a service from Hong Kong to Shanghai. Passengers would be flown back to the SAR after the six-day voyage. It also has plans for routes that would include calls at Qingdao and Dalian. Star Cruises already operates China services with stopovers in Xiamen and Hainan Island.
New Hope invests in Guilin
The Sichuan-based animal feeds company New Hope Group has signed a Yn1bn deal to build two large scenic parks and a hotel in Guilin, Guangxi province, reported HKi- Mail. The general manager of the company, Zhang Tao, said the project would also involve the construction of bars and an international convention centre.
“Guilin is among the mainland’s most favoured domestic tourist destinations,” said Zhang. “Besides, the construction of a highway linking Guangzhou and Guilin has already started.” New Hope’s chairman, Liu Yonghao, is China’s richest person, according to Forbes magazine.
New cultural centre for Guangzhou
The Hong Kong-based conglomerate Swire Pacific has taken a 55 per cent stake in a Yn4bn property complex in Guangzhou, Guangdong province. Located in the Tianhe district of the city, the Taikoo Hui Guangzhou Cultural Plaza will combine arts and cultural facilities, together with retail and commercial space and an international hotel. It will be the headquarters of Guangzhou Daily, and will feature an arts centre and a library. The complex should be completed in 2006/07 and it will be managed by Swire Properties.
China receives more tickets
The high price of tours to see China play in this summer’s World Cup finals is preventing ordinary fans from making the journey, said Wang Wen, president of the China Federation of Soccer Fans. China’s original allocation of 10,749 tickets to watch China play its three first-found games in South Korea in June was increased by an extra 4,000 tickets last month.
However, these tickets can only be bought from two approved agencies in China, which are charging Yn10,000 for a tour including one match and three days’ stay in Korea and Yn30,000 for all three games and a 10-day stay. Wang said these prices were out of reach of the ordinary football fan and that, instead, tickets were being bought by state and private companies to use as gifts or rewards for their employees.
New regulations on foreign investment have broadened the range of sectors that are now classified as encouraged or permitted for FDI.
The Regulations on Guiding the Direction of Foreign Investment took effect on April 1. The regulations repeal provisional regulations that were issued in June 1995.
The new regulations apply to all forms of foreign investment in China. Like the 1995 provisional regulations, the new rules set forth four categories of foreign investment project: ‘permitted’, ‘encouraged’, ‘restricted’ and ‘prohibited’. The regulations broadly define the scope of these categories. Whether a specific foreign investment project falls into a particular category should be determined with reference to the Guideline Catalogue of Industries for Foreign Investment (the latest version was issued on March 13) and the Guideline Catalogue of Favourable Industries for Foreign Investment in Central and Western China. Those projects that do not fall within the ‘encouraged’, ‘restricted’ and ‘prohibited’ categories are classified as belonging to the category of ‘permitted’ foreign investment.
Clarification of restrictions
The structure of certain foreign investment projects may be restricted, regardless of which category applies. The Guideline Catalogue of Industries for Foreign Investment may stipulate that foreign investment projects should be ‘limited to equity joint ventures and co-operative joint ventures’, ‘controlled by Chinese parties’ shareholding’ or ‘relatively controlled by Chinese parties’ shareholding’. Unlike the 1995 provisional regulations, however, the new regulations help to clarify these restrictions by providing the following definitions:
‘Limited to equity joint ventures and cooperative joint ventures’ means that only Sino-foreign equity and co-operative joint ventures are allowed.
‘Controlled by Chinese parties’ shareholding’ means that the investment of Chinese parties should account for 51 per cent or more of the total investment in the project.
‘Relatively controlled by Chinese parties’ shareholding’ means that in a foreign investment project, the percentage of total investment by Chinese parties should be higher than the investment percentage of any foreign party.
Like the 1995 provisional regulations, the new regulations state that ‘encouraged’ foreign investment projects that involve the construction and operation of energy and transport infrastructure and which require a large investment with a long payback period shall receive preferential treatment and may expand their relevant business scopes upon approval. The new regulations have added urban utilities to this category of infrastructure projects, including projects related to coal, oil, natural gas and electricity, railways, highways, ports, airports, city roads and sewage and waste treatment.
Incentives for exporters
The regulations also encourage foreign investment projects to export by upgrading their categorisation based on export volume. ‘Permitted’ foreign investment projects that export all of their products will be deemed to be ‘encouraged’ projects. ‘Restricted’ foreign investment projects whose export sales account for 70 per cent or more of their total sales will be deemed to be ‘permitted’ projects upon approval by the competent local authorities.
The regulations provide that ‘permitted’ or ‘restricted’ projects that can truly bring into play the advantages of China’s central and western regions may have relevant restrictions relaxed. Those that are listed in the Guideline Catalogue of Favourable Industries for Foreign Investment in Central and Western China may enjoy preferential policies for ‘encouraged’ foreign investment projects.
The most significant development is the elimination of the ‘restricted category (A)’ and ‘restricted category (B)’ distinction contained in the 1995 provisional regulations.
The new regulations simplify matters by providing that all ‘restricted’ foreign investment projects that fall within the approval limits shall be examined and approved by the relevant competent department of the province, autonomous region or municipality. However, these local authorities must still file their approvals with the competent department at the higher level and the department in charge of the industry.
This article was written by Scott Silverman, an associate at Freshfields Bruckhaus Deringer. He can be contacted by email (Scott.email@example.com).