How to model China

Many people are thinking about the Chinese economy, and all too often they apply for this the tools they are used to, for example models with competitive markets. That does not quite apply to China, despite its recent liberalization, as vast sectors of the economy are still under government control. The fact that China is different is quite apparent in the fact that it is the only economy (that I know of) where the share of labor income in national income is less than half. One needs some serious market distortion to get to such an abnormal outcome.

David Dollar and Benjamin Jones do the right thing and make the effort to model the Chinese economy like it should be done: capital controls, 5-year plans trying to maximize output, controlled internal migration with wage discrimination, state ownership of all land. With this, Dollar and Jones are able to replicate the labor income share, as well as the high investment and savings rates. They find also that if one where to relax China's special features, the economy would first deviate even more from standard characteristics. This is a model people should take very seriously for future modeling of China.

China is doing is right with managing its exchange rate

China has been heavily criticized by western politicians and policy-makers for its exchange rate policy that favors its export industry. Some have tried to explain to Chinese authorities that it is not in their best interest to follow a quasi-fixed exchange rate with the US dollar. Indeed, we know from past experience that fixed-exchange rates can be very expensive to maintain, especially in the context of large external imbalances. But is China different? After all, it financial development is
clearly less advanced than Western economies, and the Chinese economy is growing much faster.

Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis look at the optimal exchange-rate policy of a growing economy where domestic households do not have access to international markets, that is, China. They find that the optimal path for the exchange rate is first a real depreciation during a growth spurt, and then a real appreciation in the long-run. This is pretty much what China has been applying. In other words, China did everything right given its situation, and this is because the growth spurt generates a glut of savings that have nowhere to go. The real depreciation allows to take care of this current account imbalance having the central bank serve as intermediary and converting foreign assets to domestic ones for the desperate households. In some sense, we could even argue that the Bank of China has not done enough of that given the real estate bubble, which is also a consequence of this savings glut.

Imagine Chinese growth rates without misallocations

China has been growing at a very rapid pace, and many have studied how this has happened and why. Yet, when you look at the economy now, it is still remarkably inefficient, especially with a financial sector that is very far from potential. In particular, the state-controlled banks do not provide loans for the best investment opportunities, but rather disproportionately to state-owned enterprises, which obviously are not as productive as the private sector.

Robert Cull, Wei Li, Bo Sun and Lixin Colin Xu use a survey of manufacturing firms that the World Bank conducted in China in 2005 to document what determines the firm;s financial constraints. To no one's surprise, state-owned enterprises have a big advantage. But among them, those who have CEOs that are well connected with the government or the Party have is even markedly easier. This points of course to the massive misallocations within China that people are still complaining about. Imagine how much richer China could be with a better allocation of its financial resources.

But of course, one can argue that China is growing like crazy because it is transitioning from even worse misallocations, where there weren't even private savings to sustain a more productive manufacturing sector. This argument has been made, among others, by Zheng Song, Kjetil Storesletten and Fabrizio Zilibotti. Not only is China growing through rapid investment in more productive technologies, it is doing so while getting more efficient in distributing financing. And seeing how inefficient it is, there is a lot of potential growth for many more years.

Gender discrimination on the labor market in China

China is a country of contradictions. While its communist ideals dictate that all people are equal, genders are quite obviously treated differently. The country's leadership is more male-based than most (23 of 25 in the politburo) and parents routinely practice gender selection for their children, which leads to the ticking bomb of a large male population surplus (more here). Is such discrimination also practiced on the labor market in China?

Xiangyi Zhou, Jie Zhang and Xuetao Song went through the trouble of sending about 20,000 fake employment applications on various major Internet bulletin boards and analyzed the responses they got. The results are damning. There is signification discrimination, but in surprising ways. State-owned enterprises tend to prefer males. Foreign and private firms go the other way and tend to prefer females. The public sector is rigid and follows rules, so it seems deeply ingrained to privilege men despite all the rhetoric. The private sector is more flexible and, I suppose, takes opportunities where they are, and hiring discriminated women seems to be the way to go. On more lesson on how free markets can be powerful adjusters.

China's biggest threat: its men

Many people in the Western world are afraid of China as a new economic superpower. To a large extend, this is because of a mistaken belief that the world economy is a zero-sum game, and any progress in China is to the detriment of currently rich economies. Of course, rich economies mostly benefit from China's growth, as it makes some goods cheaper and opens new markets. And the richer countries are, the less they will want to get into destructive wars, if this is what you are worried about.

If there is a threat, it is rather from within China. First, there is a huge number of undocumented internal migrants who do not have access to social services. Second, as Jane Golley and Rod Tyers describe, there is a time-bomb resulting from an imbalance in the sex ratio. The surplus of men leads families to save too much in order to compete for scarce women to marry their sons to. The imbalance is so strong that regular immigration or human trafficking are not sufficient. But the most striking menace comes from the discouraged single and low-skilled men, who could amount to a quarter of all men of reproductive age by 2030, who are prime candidates for a criminal life. And reverting such trends is going to be very difficult.

Are the Chinese capital controls optimal?

China is currently amassing large foreign reserves while imposing internally capital controls. Does this make sense? Wouldn't an economy that has the ability to create such surpluses want to participate more fully in world markets? One should not forget that these foreign reserves are accumulated thanks to a positive trade balance and a fixed exchange rate, not thanks to a particularly well functioning capital market in China. In fact, the financial sector in quite under-developed in China, and most households have access to nothing more than simple bank accounts.

Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis build a model where the central bank has access to world market, but domestic households not. This enables the central bank to impose a different interest rate than the world interest rate, but it steady-state it is best to replicate an open economy: accumulate reserves and issue domestic debt at the world interest rate. If the economy grows rapidly, though, you want to have a higher interest rate domestically while imposing capital controls, that is, one needs to prevent arbitrage. But then, intertemporal substitution needs to happen through international reserves, as households cannot do it.

What is intriguing here is that we have a situation where open markets are welfare inferior to restricted ones with a reserve accumulation policy. Usually, we think that free markets would work best, especially as here there is no moral hazard, systemic risk, or other distortion. The reason is that borrowing constraints are binding as the economy converges towards steady state, and it cannot provide adequate intertemporal allocation in open markets. The central bank needs to help, and needs to differentiate interest rates to do so. That can only happen with capital controls.

Inter-provincial risk sharing in China

Despite widespread claims, China is still far from a capitalist economy. There is still a considerable amount of command-and-control, and the state-owned enterprises still comprise a large and heavily subsidized sector of the economy. One aspect of a command economy with a (still) poor finance and insurance sector is that it can enforce some sharing mechanism to alleviate the consequences of local business cycle shocks or offer some redistribution across geographical regions. Such mechanisms are also in place in Western economies, mostly implicitly (for example, a national unemployment insurance) and when it is explicit, it leads to tensions as some always pay and some always receive (examples: Canada, Bolivia). Anyway, back to China.

Julan Du, Qing He and Oliver Rui find that the state-imposed fiscal channel of redistribution during the business cycle has a relatively minor impact: it dampens business cycle fluctuations by only 9%. A much larger impact comes from movements in labor, which is actually surprising as the state actively impedes such movement with an internal passport system and undocumented workers face major hurdles for public services. Still an in all, there is very little inter-provincial smoothing going on. I would have expected the central government to do a much better job in this case.

Understanding Chinese household savings

It is not a secret that the Chinese are saving like crazy. The big question is why their savings rate is the highest in the world and it was addressed before on this blog (more below). The explanation that this would have to do with life-cycle considerations as the population ages (with few children) has by now been largely dismissed. So can explain it?

Riccardo Cristadoro and Daniela Marconi make the point that we really need to look at households, as firms or the government have not increased their savings rate sufficiently. Using panel data, they notice that the savings behavior differs markedly across provinces. And one aspect that does as well vary across provinces is the provision of social services and the access to credit. Thus they tie the high savings rate with the need to build up precautionary savings. This corroborates my previous posts about increased idiosyncratic risk and the reform of the public pension system.

How is China now planning its economy?

Since 1978, China has undergone a fundamental and very successful reform from a planned economy towards a market economy. But one should still keep in mind that this is still an autocratically governed country where technocrats call the shots at all levels. China is still working with five-year plans and the economy is still tied to administrative goals. SO how does economic planning work in China nowadays?

Gregory Chow offers some insights, in particular on how this planning has recently become more important due to the global economic crisis. Administratively, policy is guided by the five-year plans, which interestingly have recently included new sections on welfare and management of society, making apparent some worries about the adverse effects of market economies and rapid development (or democracy when people can complain?). The remarkable part of these plans is that explicit targets are set, and policy is in a major way oriented towards these targets. Of course, the government still controls directly a considerable number of state-owned enterprises. And it has the traditional tools of policy in a market economy at its disposal to influence the rest of the economy. These policies are coordinated at all levels thanks to the very central nature of government.

In some sense it would also be good for market economies to also set some targets for policy. In fact, this is what politicians should be arguing about and then let technocrats put policy in place to achieve these targets. I would not mind targets like putting a man on Mars by 2020, making sure everyone in covered by health insurance by 2015, get 50% of commuting kilometers on public transportation, or defense expenses being completely dedicated to defense (and not attack) by 2015, for example. In fact, the World Bank has well-defined targets for developing economies. In do not see why this should not be applicable for developed ones. At least it would make governments capable of rallying support for some goals and be explicitly accountable.

Why is the Chinese savings rate so high?

The current global imbalances, at least those between the US and China, are only possible because China is currently saving a historically high share of its income. Various theories have been advanced to explain this surge in the savings rate: 1) Economic reform has increased household-level uncertainty and thus precautionary savings. 2) Forces have shifted from consumption-oriented households to savings oriented businesses. 3) Demographics and the life-cycle combined with the growth in income lead currently to high savings rates because savings change through the life cycle and thus fluctuations in the dependency ratio become important.

As Carl Bonham and Calla Wiemer point out, the savings rate has not been uniformly high and is in fact consistent with the changes in the dependency ratio. The savings rate increased through the 1980s to peak at 41.9% in 1995, then "bottomed" at 37.7.% in 2000, before surging back to 51.4% in 2008. The current global imbalance occurs in part because, unlike before, investment rates are restricted by policy, and stand at 43.5%. A modest decrease in the savings rate can rebalance things.

To test the three theories against these staggering numbers, Bonham and Wiemer use a structural VAR and determine the latter one is the most important, while the others cannot be dismissed. I am not particularly fond of VARs to test theories, they should rather just describe the data, but the evidence is quite compelling in this case. Of particular interest is that one can forecast the savings rate, as the dependency ratio is quite predictable. And this forecast shows that Chinese savings rates have peaked last year and will decrase quite significantly over the next decade. If true, this should reduce considerably the pressure on China to do something about current imbalances.

Lords, bondage, Hegel, and ... the US-China current account balance

Current global imbalances are mostly the mark of what is happening in the United States and China. And how the two are interacting, one could argue, is all that is going to matter. Pessimists view the current imbalances as the result of large domestic distortions and problems in international financial and monetary markets. Optimists consider the situation to be part of a normal adjustment and everything will automatically be fine.

Célestin Monga tries to reconcile both views using Hegel's approach of self-consciousness and the lordship-bondage relationship. Yes, we can apparently understand global imbalances using philosophy. The idea is the following: The Unites States and China have become largely interdependent and cannot ignore each other. Even if one has dominating position on the other, it can exploit the situation. Think of a fight to death between two adversaries. The winner becomes the master, but there is nothing left to dominate as the other is dead. The same would happen with the other winning. Both realizing that they so reliant the other, the solution is not to kill the loser, but to enslave him. But over time, the slave adapts and makes the master totally dependent on him and becomes more powerful.

How does this brings us to US-China relations? First ignoring each other, the US takes center stage with the Industrial Revolution, and China's 5000 year history takes a back seat. But since China has regained economic power and is on the verge to become the second economy in the world, both economies wage a battle for economic supremacy, best visible on the position with respect to the "manipulated" renminbi/dollar exchange rate (US position) and the "concerns" about the US dollar (China position). But both cannot ignore how intertwined they are, just have a look at the trade and capital accounts. This implies that they cannot unilaterally take policy decisions without considering very seriously how they other would react. They are locked in a Nash equilibrium, and at this point both are masters and slaves.

Should we not use philosophy and psychology instead of macroeconomics to understand global imbalances? Is this an example of behavioral economics going too far? We tend too often to think that countries act like a representative agents, and this analysis takes it to the extreme. One cannot ignore that some factors here are solely dependent on government decisions (exchange rate, monetary policy), that make it look a country acts as one, and is thus locked in a two player game. But this hides considerable heterogeneity of agents within, but while they face the same prices, their impact varies a lot: some are exporters, some importers, some directly, some indirectly. And government policies are a reaction to all this heterogeneity. I think our macroeconomic models are still more useful than Hegelian conjectures.

Growth leads to savings, not vice-versa

Fast-growing countries, like currently China, have very high savings rates. Data indicates that causality runs from growth rates to savings, and not the reverse. In theory, this is puzzling. Such high growth rates originate in rapid productivity improvements. This leads to high returns for capital and thus one should see high investment (and savings). However, returns for savings in such countries are very low. Why are people savings so much then?

Yi Wen finds one way to justify this: precautionary saving. We know that whenever there is a motive for precautionary savings, this can be rewarded with interest rates below the discount rate. And this is triggered by borrowing constraints. And it is well known that the Chinese financial sector is still severely underdeveloped.

The actual mechanism at play is obscure to me. The paper reasons that when permanent income increases, it is savings that increase instead of consumption, because of the borrowing constraint. The only way I can see this happening is when the uncertainty increases faster than incomes, or if utility is twisted in some way. But I do not seem to see either. While the author claims to have made a model that is tractable and analytically solvable, it does not appears to help in any way to understand what is going on. And Yi Wen does not seem to offer any explanation either.

Savings rates and public pensions in China

Chinese savings rates are very high and increasing, which have allowed the current paradoxical situation that an emerging economy is massively lending to industrialized economies, in particular to the most advanced, the United States. But why is this savings rate so high? While the popular opinion seems to be that Chinese households just cannot consume fast enough given the very high growth rates of their incomes, closer inspection of household level data reveals a very different picture.

Take for example Jin Feng, Lixin He and Hiroshi Sato, who find that changes in the pension system can explain all of the increase in the savings rate from 17% in 1995 to 23% in 2004. The pension system has been reformed to become less generous, prompting households to compensate with their own savings. Add to this that precautionary savings is not only motivated by retirement, but also by the fact that economic uncertainty has significantly increased with the liberalization of labor markets, you have the perfect storm for a massive increase of savings rates as household try to reach an acceptable buffer stock. Public appeals for them to consume more will do nothing.