China has experienced an incredible rate of growth in recent decades. According to the April 2015 issue of the IMF World Economic Outlook database, China’s GDP based on current prices has grown from about USD 0.31 trillion in 1980 to USD 10.38 trillion in 2014. China’s share of the world’s GDP, based on purchasing power parity valuation over the same period, has increased from 2.3 to 16.32 percent. Furthermore, as of 2014, China’s GDP, based on purchasing power parity valuation, has exceeded that of the United States. The recent rapid transformation of China’s economy is nothing short of miraculous.
Looking forward, China faces huge challenges that could potentially impede its growth as well as destabilize its economy. The OECD Economic Surveys: China March 2015 report shows the rate of real GDP growth in China has declined in the last few years and dipped below 10 percent as China works out the excesses in the property market and several heavy industry sectors. In 2014 China’s real GDP growth rate declined to 7.4 percent, about half the rate during its heyday, albeit still high in comparison to the developed economies. The ratio of job vacancies to job seekers for college graduates has improved but is still less than one, implying many graduates are still unable to find employment. These examples are just a glimpse of some of the challenges China faces. Given the increasingly critical role China plays in the global economy, the question of whether China’s economy will continue to remain stable and grow is of significant interest not only to China but also the rest of the world. This special issue contains five articles that examine the complex challenges that threaten the stability and growth of China’s economy.
The first article titled “A Model of Capital Allocation, Education, and Job Choice in China” by Lien, Wang, and Zheng, (2016) looks at how the Chinese government’s investment policy affects the productivity and wage gap between high- and low-skilled workers in China and the long-term impact of such a policy. China, like many developed nations, is confronted with an aging population. As the size of the working-age population declines, it is even more crucial for the government to invest adequately and wisely to squeeze every bit of productivity out of the working-age group. Clearly, making adequate investments is not an issue, as pointed out by the authors. The rate of investment in China was 35.3 percent in 2000, and since then has increased to 48.6percent in 2010. While the investment rate in China is substantially larger than the rate for the rest of the forty largest world economies which average 22.4 percent (Bai, 2013), China has not enjoyed a rate of return on capital commensurate with their huge investments.
Lien et al. (2016) claim the low rate of return on capital originates from government policy that favors investment in state-owned enterprises and low-skilled industries. Such biases in the policy result in misallocation of the huge investment capital from the government, leading to overinvestment in some sectors and underinvestment in others. They cite Hsieh and Klenow (2009), as well as Song and Wu (2013), to give a sense of the magnitude of the impact due to the misallocation. The estimates from Hsieh and Klenow reveal that China could potentially experience a 30–50 percent gain in total factor productivity if resources in factor markets could be reallocated to attain the degree of marginal product parity available in the United States. Song and Wu estimate that capital market distortions have resulted in aggregate revenue losses of around 20 percent for Chinese firms. Such biases in the government investment policy could also have long-term repercussions on the country’s productivity. To better understand this issue, Lien et al. (2016) developed a game theoretic model to capture the dynamics of workers’ decisions in the labor market in response to the government’s investment policy. This article is one of few to take a game theoretic approach to model how government policy biases affect labor market conditions.
The model closely mirrors the reality Chinese workers face, where the government makes policy decisions, taking workers’ qualifications as given, and workers subsequently make labor market choices. Their analysis reveals the wage gap between high- and low-skilled workers’ contracts as the government increases its investment in low-skilled sectors. The authors’ results mirror what happened in China following the introduction of a four trillion RMB (equivalent to USD 586 billion) economic stimulus package in 2009 and 2010, to counter recessionary forces arising from the 2008 global financial crisis. Quarterly data from the National Bureau of Statistics of the People’s Republic of China shows that the wage growth of low-skilled migrant workers exceeded that of high-skilled urban workers by an average of 2.28 percent in 2012 and by an average of 3.72 percent in 2013. The high wage rate enjoyed by low-skilled workers incentivizes youth to choose work over school potentially leading to a distortion in the education choices of the labor force. This phenomenon could impede China’s productivity in the long run if more and more youth drop out of school early to seek work. China, which is facing a shrinking working-age population, cannot afford such a shift in educational priority of her labor force.
The authors also point out the government’s investment strategy could create other social problems not studied in their model. Two glaring examples of such problems are urban overcrowding and “left-behind children” (Gao, 2013). As low-skilled workers from rural areas move to urban areas to fill the labor demand for the image projects, they contribute to urban crowding. These migrant workers often do not have urban residence permit or Hukou, making it difficult to take their children with them. Consequently, migrant workers leave their children behind to be raised by their grandparents, relatives, or to live on their own. This serious social problem could undermine the country’s stability and productivity in the long run. Lien et al.’s work (2016) shows that shortsighted investment policy could have significant and far-reaching long-term consequences on the country’s economic stability and growth.
“The Effect of Access to Public Debt Market on Chinese Firms Leverage” by Ding, Wu, and Zhong (2016) explores changes in financial leverage firms experience as the debt market becomes more accessible. In theory, providing firms better access to the debt market should help to stimulate growth in China provided that debt financing lowers the weighted average cost of capital thereby increases the set of positive net present value projects available to firms. Historically, as Ding et al. (2016) argue, publicly traded firms, particularly non-state-owned enterprises (non-SOEs), rely heavily on equity financing. As recent as 2002, debt financing accounted for only 3.46 percent of total external financing. One reason for this is the absence of a well-developed debt market in China.
Until recent years, it was nearly impossible to obtain objective and reliable material financial information about firms in China. The dearth of quality financial information led to severe information asymmetry between firms’ insiders and outside investors. For example, for equity holders, Ding, Guedhami, Ni, and Pittman (2014) find that sophisticated foreign institutional investors significantly underperform domestic investors in Chinese SOEs due to severe information asymmetries in these firms. For creditors, lenders charged prohibitively high rates of borrowing and imposed significant hurdles on firms that sought to borrow. These factors made it difficult for the debt market to flourish. The information asymmetry problem also prompted high quality firms to venture overseas to seek quality certification from reputable agencies, for example by listing their firms on a reputable exchange, such as the NYSE (Beladi, Oladi, & Tay, 2012; Tay & Oladi, 2011). There was a clear need for a quality certification mechanism in China to mitigate the information asymmetry problem. In response to this dilemma, credit rating was introduced into China in the early 2000s. Since then, an increasing number of firms have gained access to public debts. Ding et al. (2016) show the debt ratio of firms that have access to the public debt market is significantly higher than those firms without access. Specifically, everything else being equal, gaining access to the public debt market significantly increases the debt ratio by 3.44 percent, with the increase concentrated in long-term debt. They further find non-SOEs enjoy greater benefits from access to public debt market than SOEs as evidenced by an increase in their total debt ratio and long-term debt ratio. For SOEs, the increase in long-term debt is offset by the decrease in short-term debt. The response of firms, as revealed in the evidence suggests that non-SOEs which do not have privileged access to capital were operating with less than optimal capital structure and are starving for low cost debt capital. Since a well-developed debt market will help to enhance capital market efficiency by facilitating optimal allocation of capital and lower cost of capital, in due course it should promote economic growth. The evidence provided makes a case for continuing efforts to build a well-developed debt market that is accessible to all firms in China. This article is the first to present empirical evidence on how gaining access to the public debt market affects a firm’s capital structure in China.
The next article, “Domestic Market Integration in China: The Role of the Financial Sector” by Yang and Ye (2016), examines the effect of financial sector development on spatial market integration in China, and explores the differential impacts of financial sector development across regions. This work is timely as China undergoes an economic makeover to focus more on developing a consumption-driven economy while reducing its dependence on external markets for growth. As a result of the effort, the contribution to GDP from the service sector surpassed that of the manufacturing sector in 2013.
Contrary to what one would expect, Yang and Ye (2016) find development of the financial sector undermines spatial market integration in China. According to the authors, domestic markets become more fragmented as the financial sector expands and becomes more efficient. The source of this problem lies in the inconsonant relationship between local governments and state-owned commercial banks that dominate the financial sector. Over the past decades, commercial banks have experienced rapid growth with the help of local governments. Although these banks are supposed to be autonomous, in practice these banks are often pressured by local governments to allocate banks’ capital to support their agenda. Local government officials concerned about their own career development make decisions that are good for the larger economy only if doing so helps to advance their own agendas. Consequently, the impact of the finance sector growth on market integration differs between economically developed and underdeveloped areas; local governments are more likely to hinder market integration in developed provinces than undeveloped ones. This is the first empirical work to investigate the impact of financial development on spatial market integration in China.
The fourth article “Location Preference in Migration Decision: Evidence from 2013 China Household Finance Survey” by Ye and Wu (2016) investigates the individual migration decision and preference for metropolitan areas in urban China. China has experienced extensive internal migration during the last three decades. As of 2013, there are 163.4 million migrant workers in urban areas, constituting approximately 40 percent of the Chinese urban labor force (NBS, 2013). This substantial inflow of migrants provides essential labor inputs for expanding industrial sectors; nevertheless, this also leads to many complex challenges for Chinese policy makers, including labor market discrimination, urbanization, and income-inequality. Recently, the Chinese government initiated the gradual removal of the institutional Hukou system to promote permanent migration and narrow the rural-urban income gap (Fan, 2005). Nonetheless, the large number of migrants, in addition to rapid urbanization, still creates great tension upon pension, health, and other social benefit systems in destination urban sites (Liang, 2001).
Previous studies have primarily focused on the migration from rural to urban sectors (hereafter “rural migrants”) to examine the causes and consequences of the substantial flow of labor. With rapid urbanization, the size of urban migrants has increased and been trending upward. Urban migrants exhibit important features that differentiate themselves from the poorly-educated and low-skilled rural migrants. Urban migrants usually have a higher level of human capital and higher interprovincial mobility (Chan, 2012; Wang, 2008). Despite the increasing importance of the urban-to-urban migration, research on this unique group of urban migrants has been scant largely due to the unavailability of micro-level survey data.
This study uses a unique and recent dataset— the 2013 China Household Finance Survey (CHFS)—to explore urban-to-urban migration in China. The authors present three stylized facts regarding urban-to-urban migration in China. First, although the eastern provinces attract the most skilled urban migrants, most interior provinces suffer from a massive outward migration. Second, recent cohorts of urban migrants with higher skill sets departed their home city at a younger age. Third, Beijing, Shanghai, Guangzhou, and Shenzhen (hereafter referred to as “BSGS”), the first-tier cities in China, have been gradually losing their dominant popularity among the younger generations of urban migrants. In addition to providing evidence on the patterns of urban migration over time, this research also finds that, despite their higher skill level and labor income, urban migrants continue to encounter significant occupation segregation and welfare disparity in the urban labor market. Urban migrants also show signs of larger intragroup income disparity, implicated by their lower home ownership rate but better housing conditions. In all, this study provides a comprehensive picture of the current urban-to-urban migration in China. It highlights another channel through which the income inequality arises among different regions in China, and elucidates public policies concerning future immigration trends encountered by Chinese policy makers.
The last article “Does the Introduction of Stock Index Futures Destabilize the Spot Market? Some Cross-Country Evidence from Asia” by Dong, Fan, and Zhang (2016) studies the effect of the introduction of SIFs to the spot market in China and six other Asian markets. Various stock index futures (SIFs) products have been used by a large number of investors in the United States, Europe, and some Asian countries since its first introduction in 1982. China’s stock market introduced HS 300 index futures in 2010 to allow investors to hedge their positions and profit from falling as well as rising markets. The introduction of SIFs into China suggests that the Chinese authorities have become more open to financial innovation in the security market. Meanwhile, it creates a considerable challenge for the market and regulators due to the controversy of its impact on the spot market. The Shanghai Composite index increased from 3234 to 5176 from January 2015 to June 2015. However, from June to August 2015, the Shanghai stock exchange lost one third of its value. The role of SIFs in Chinese stock market was challenged, and the authorities eventually decided to constrain the trading of SIFs in September 2015, which resulted in a 90 percent decline in the trading volume of SIFs.
The effect of SIFs on the financial market, particularly on the spot market, has been under debate for many years. On the one hand, arbitrage is necessary for a stock market to become more efficient. On the other hand, futures trading could cause large fluctuations in the financial market and increase market volatility. In this article, based on the literature on noise traders and rational bubbles, the authors develop a hypothesis that, if a bubble exists in the stock market, the introduction of SIFs will drive out the bubble through arbitrage behavior, which may cause a price reversal and increase the volatility in the spot market. The authors construct a comparative study based on data from China and six other major stock markets in Asia, namely Hong Kong, Japan, Malaysia, Korea, Taiwan, and Singapore, and provide evidence that the impact of SIFs on the spot market can be affected by the market condition at the launch time. Especially, the Chinese market experienced a significant decline after the launch of SIFs, and market volatility increased significantly. However, SIFs do not have a long-term effect on the spot market as the market returned to its previous level after approximately fifty days. Therefore, the authors conclude that SIFs may not be the major reason for the market crash in China and there are other fundamental causes of the fluctuation in the spot market. If authorities want to ensure a healthier security market, more fundamental problems should be resolved, such as the quality of listed firms, the information disclosure system, and insider trading.
The collection of articles in this special issue examines diverse issues to deepen our understanding of some of the complex challenges that China faces. Lien, Wang, and Zheng (2016) show using a game theoretic model how short-sighted government’s investment policy can diminish the incentive for pursuing education and elaborate how such policy can also create other social problems. The empirical evidence presented by Ding, Wu, and Zhong (2016) show that firms, particularly the non-SOES, choose to increase their financial leverage as they gain access to debt market and in doing so presumably nudge their capital structure closer to the optimal level while lowering their overall cost of capital. They highlight the need for China to continue in her efforts to create a well-developed debt market. Yang and Ye (2016) present empirical evidence to show that the development of the financial sector in China impedes domestic market integration possibly because of interference from local governments. The stylized facts of the current urban-to-urban migration in China presented by Ye and Wu (2016) highlight the challenges of urban migrants encounter in the urban labor market and another channel through which income inequality arises among different regions in China. Dong, Fan, and Zhang (2016) document a largely short-term and non-lasting impact of SIFs on the Chinese stock market and suggest that SIFs may not be the major reason for the 2015 market crash in China and the government should work on more fundamental problems to foster a healthy security market. The challenges brought to light in this special issue could have long-term consequences on China’s economic stability and growth if not addressed appropriately.
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Some Challenges to Economic Growth and Stability in China
Author(s):Xiaoya (Sara) Ding & Nicholas S. P. Tay