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 longer-term, coverage will need to be extended to rural workers and those now in the informal sector in cities, but with flexibility to allow some 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 longer-term 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 external 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