A Real Model of Transitional Growth and Competitiveness in China

WP/08/99



A Real Model of Transitional Growth and
Competitiveness in China

Leslie Lipschitz, Céline Rochon and
Geneviève Verdier

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© 2008 International Monetary Fund
WP/08/99



IMF Working Paper



IMF Institute

A Real Model of Transitional Growth and Competitiveness in China1

Prepared by Leslie Lipschitz, Céline Rochon and Geneviève Verdier2

April 2008

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

We present a stylized real model of the Chinese economy with the objective of explaining two
features: (1) domestic production is highly competitive in the sense that an accumulation of capital
that raises the marginal product of labor elicits increases in employment and output rather than only
in wages; and (2) even though the domestic saving rate is high, foreign direct investment is also
substantial. We explain these features in terms of a conventional neoclassical growth model—with no
monetary or nominal exchange rate policy—by including two aspects of the economy explicitly in the
model: (1) low production wages are sustained by a large reserve army of rural labor which drives
internal migration, and (2) domestic capital is distinct from importable capital and complementary
with it in production. The results suggest that underlying real phenomena are important in explaining
recent history; while nominal renmimbi appreciation may dampen price and wage increases, it would
probably not change the real factors that have sustained rapid growth.

JEL Classification Numbers: F21, F22, F41, F43, O41, C15
Keywords: foreign direct investment, saving, investment, surplus labor, migration
Authors’ E-Mail Addresses: llipschitz@imf.org; Celine.Rochon@sbs.ox.ac.uk;
gverdier@imf.org

1 A previous version of this paper circulated under the title “Blessings in Disguise: Surplus Labor and Excess
Saving in China”.
2 International Monetary Fund, Washington DC, 20431, Said Business School, University of Oxford, Park End
Street, Oxford, OX1 1HP, UK, and International Monetary Fund, Washington DC, 20431, respectively. We would
like to thank Vivek Arora, Jahangir Aziz, Andrew Feltenstein, Tarhan Feyzioglu, Ron McKinnon, Alex
Mourmouras and seminar participants at the IMF Institute and the Said Business School for helpful comments and
suggestions. Any errors or omissions are our own.

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Contents Page


I. Introduction ......................................................................................................................3

II. Stylized Facts ...................................................................................................................5


III. Model ...............................................................................................................................8

A. Households ...............................................................................................................9

B. Firms .......................................................................................................................11

C. Exogenous Shocks ..................................................................................................13

D. Equilibrium.............................................................................................................13


IV. Results............................................................................................................................14

A. Calibration ..............................................................................................................14

B. Impulse Response Functions ..................................................................................15

C. Simulation...............................................................................................................16

D. Transition to Steady State.......................................................................................16

V. Conclusion.....................................................................................................................17

References.............................................................................................................................28

Appendix...............................................................................................................................31

Tables
1. National Saving Rate, 2006...........................................................................................19
2. Relative Hourly Wage in Manufacturing, Selected Economies, 2002..........................19
3. Income of Urban and Rural Households and the Urban-Rural Gap (RMB) .................20
4. Summary Indicators of Saving and Investment ............................................................20
1
5. Convergence and Transition Half Life α =
..............................................................27
3
1
6. Convergence and Transition Half Life α =
..............................................................27
2
7. Simulation
Results.........................................................................................................27

Figures
1. Net Capital Flows into China ........................................................................................21
2. Saving and Investment ..................................................................................................22
3. Productivity
Shock ........................................................................................................23
4. Foreign Interest Rate Schock ........................................................................................24
5. Foreign Output Shock ...................................................................................................25
l
z
6. Transition to Steady State when 0
0
=
= 9
.
0 ............................................................26
*
*
l
z

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I. INTRODUCTION
The Chinese economy has experienced remarkable growth since the late 1970s. The last decade has
been marked by clear signs of Chinese success: rapid export-led growth sustained by highly com-
petitive real wages, and high investment financed both by substantial domestic saving and by large
inflows of foreign direct investment (FDI). China’s surprising performance has enabled its economy
to absorb some of its large underemployed or unemployed labor force — its so-called surplus labor.
There has been a sharp debate among economists on the economic strategy of the Chinese authorities-
especially their exchange rate policy. Some have argued that this strategy is sustainable and that,
indeed, it will force other countries back into a system of fixed exchange rates (Dooley, Folkerts-
Landau and Garber (2004a, b)). Others have taken a much less benign view: they see the Chinese
strategy as essentially a mercantilist “beggar-thy-neighbor” stance that is undermining the mecha-
nisms of international balance-of-payments adjustment and that, moreover, will prove detrimental to
containing inflation and maintaining financial stability in China itself (Goldstein and Lardy (2005)).
But a surprising element of much of the discussion is the implicit assumption that nominal exchange
rate policy can exert protracted influences on the real economy.
This paper starts from the view that an understanding of the extraordinary real economic conditions is
fundamental to an assessment of the implications (and the sustainability) of the Chinese development
strategy. Consider the following stylized facts:
• per capita growth has averaged 8.5 percent over the last decade;
• investment has averaged over 36 percent of GDP since 1996;
• the national saving rate (with both households and entreprises contributing) has been extraor-
dinarily high by any standard of comparison — in 2006, it was 54 percent (Table 1);
• notwithstanding the high national saving rate, there has been a significant inflow of foreign
direct investment (Figure 1);
• wages in manufacturing have been very low by any international standard (Table 2) and rural
incomes have been even lower than urban incomes — by a considerable margin (Table 3).
The research strategy of this paper is straightforward. We propose a simple neoclassical growth
model that takes cognizance of the fundamental real features of the Chinese economy. It is a real
model with no monetary-cum-nominal-exchange-rate policy, and the objective is to determine which
of the basic characteristics of the Chinese pattern of development will be captured by this model.
In our model, China is a small open economy in the sense that its actions cannot affect the interest
rate at which it borrows, but is a monopolistic producer in the goods market. The model has two
important features. The first is imperfect capital mobility of a particular type: the model economy
has two types of capital — domestic and foreign — and, while the latter can be borrowed on in-
ternational capital markets at a fixed rate, the former can be generated only by domestic saving.
(This is intuitive if one thinks of domestic capital as, for example, human capital.) Both kinds of
capital are necessary for production, and the two are complements in the production process — that
is, the marginal product of one type of capital is increasing in the level of the other. This means
that saving more domestic capital increases the marginal product of foreign capital, and increases

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inflows of FDI. Monopolistically competitive firms combine domestic and foreign capital with labor
to produce a domestic good which is sold on both domestic and foreign markets.
The second crucial feature of the model is surplus labor. The economy depicted is an urban economy
where all production takes place. The agricultural sector is assumed to be exogenous. It produces
a homogeneous agricultural good with no growth. The rural sector has an excess of laborers willing
to move to the urban areas whenever the urban wage exceeds the rural wage. The speed at which
migration occurs depends on the degree of labor mobility.
These two features of the model drive the results. We calibrate the model to the Chinese economy
and find that the model can explain the combination of high saving coupled with FDI inflows, high
investment, low wages, and competitively-priced domestic goods on world markets. For example, any
increase in the domestic capital stock raises the marginal product of foreign capital and labor; this
immediately attracts labor in from the rural sector and foreign capital in from the rest of the world
such that output increases to the point where the marginal products of capital and labor are back to
their initial levels.
We look at various experiments — the response to productivity, foreign demand and interest rate
shocks — to illustrate the mechanics of the model. We also simulate the model and compare the
moments of key variables under various assumptions about parameters. We find that the variance of
both wages and the real exchange rate is lower in a model with higher labor mobility, particularly if
the source of the shock is foreign demand. In addition, we characterize the transition of the Chinese
economy to its steady state from an initial condition for surplus labor close to what is currently being
observed in China. We conclude that if there is still a substantial surplus of labor, then the current
transition could last an additional decade.
Our analysis is undertaken without ever specifying a monetary channel. This may seem surprising
as much research has focused on how monetary policy is being used to maintain an undervalued
currency. In addition, much press, academic and popular, has been given to the large accumulation
of international reserves by the Chinese monetary authorities. We make two observations on these
points. The first observation relates to the accumulation of reserves and the relative fixity of the
exchange rate of the renminbi. Prasad and Wei (2005) argue that reserve accumulation since 2001
may have been due to an undervalued currency and/or speculative inflows. Our paper is largely
silent on the issue of reserve accumulation unrelated to FDI flows; this may be important but it is
beyond the scope of the current analysis. We do imply, however, that, while monetary policy may
have influenced the value of the renminbi, an appreciation of the currency now would not change the
underlying real phenomena —in this case the particular combination of imperfect capital mobility
and an excess supply of labor — that have played an important role in the recent history of rapid
growth. On the other hand, any monetary/exchange rate policy that seeks to restrain an equilibrat-
ing real appreciation as underlying conditions change will probably set off a serious inflationary spiral.
Our second observation relates to the unusual pattern of Chinese saving, investment, FDI and terms
of trade: a multiplicity of complex explanations have been suggested but the one that emerges from
our model is clean and simple. On saving, some have argued that observed household savings are
largely demographic. Modigliani and Cao (2004), for example, make life-cycle/retirement arguments
for the high Chinese saving rate: saving by the young, spurred by high growth, offsets any dissaving
by the old. In addition, the one-child policy in China has forced families to substitute financial

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saving for children in the planning for retirement. Both Kuijs (2006) and Chamon and Prasad
(2007) find that a decrease in savings in China is to be expected because of the aging of the popu-
lation, but that this will be offset by the increase in a share of high savers, namely workers in the
latter halves of their working lives. Chinese savings are also seen by some as precautionary and
a response to various distortions that leave households unable to insure themselves through other
means. Blanchard and Giavazzi (2005) and Kuijs (2006) among others cite in particular the lack of
government spending on health, and social safety, the existence of credit constraints, and the lack
of financial sector development. Aziz (2006) argues that the high saving and investment rate may
be the result of distorted financial incentives that encourage low ratios of consumption to GNP and
high investment/GDP ratios. Other arguments include the uncertainty linked to the transition to
a market economy and the lack of international portfolio diversification (Chamon and Prasad (2005)).
A variety of explanations have also been suggested for observed FDI flows: directed policy in the
form of tax incentives or legal restrictions on other capital flows (Prasad and Wei (2005)); incentives
such as open economic zones, the size of the Chinese market and the available infrastructure (Tseng
and Zebregs (2002)); institutional weaknesses such as preferential bank credit flows to state-owned
enterprises that have required private firms to seek financing through ventures with foreign firms.
Many authors have examined China’s exchange rate system (e.g. Mundell (2004), McKinnon (2007)).
One of the most well-known and controversial explanation for recent developments in China is that
advanced by Dooley, Folkerts-Landau and Garber (2004a, b). It is perhaps closest to our effort in
the sense that the paper attempts to explain a large number of stylized facts at the same time. In
addition, part of the explanation relies on the existence of a large supply of unemployed labor. The
authors describe the so-called revived Bretton Woods system as China accumulating reserves in the
form of US securities which then serve as collateral for US firms investing in China. The resulting
export-led growth allows China to absorb its large surplus of unemployed or underemployed workers.
Our story however, does not rely on any implicit agreement between China and the United States, or
indeed upon the notion — something of a stretch in our view — that net official reserves are seen as
collateral by private FDI investors. What matters instead is a structure of production that depends
on three complementary factors and the particular supply of these factors. With these features, our
exogenous growth model with optimizing agents provides a reasonable explanation for the recent
behavior of saving, investment, capital inflows and goods prices in China.
Note that our work cannot be used as a faithful representation of the Chinese economy. Our model is
much too simple and stylized to be tested quantitatively against the data. It does, however, provide
plausible channels through which key stylized facts can be explained.
The paper is organized as follows. Section II reviews the stylized facts we propose to match. Section
III presents the model. Section IV presents the dynamics of the model as well as its qualitative
predictions while Section V concludes.
II. THE STYLIZED FACTS
The characteristics of Chinese growth are well known. Nevertheless, we document a list of three styl-
ized facts which our model will either take as given or will try to reproduce. Our view is that China’s
economy can be described by the following key facts: (i) China’s recent economic performance is due

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in large part to its high investment rate fueled by both domestic and foreign sources of financing;
(ii) Chinese wages are very low by international standards but relative wages are much higher in the
urban areas; (iii) China’s agricultural sector has a large reserve of surplus labor. We turn to each of
these in turn.
Fact 1: Saving, Investment and FDI are high
As illustrated in Table 1, China’s saving rate is substantially higher than average. It is twice the
level observed in low-income countries and almost 15 percentage points higher than the average for
upper-middle income economies. Figure 2 shows that this has been the case for some time, as the
saving rate has remained around 40 percent for the past twelve years.
Households savings are high, at about 20% of GDP, but are not the only contributor to overall savings
as shown in Figure 2. Savings by firms constitute a large portion of observed savings. In fact, many
authors (Kuijs (2005, 2006), Aziz (2006), Barnett and Brooks (2006)) have documented the Chinese
enterprises’ tendency to reinvest profits and to follow a low-dividend policy. As shown in the next
sections, this is consistent with our model in which monopolistic competitive domestic firms who
collect excess rents must invest in domestic capital in order to attract foreign capital. Government
savings also contribute to the total. Kuijs (2005) notes that this is a result of a growth-oriented pol-
icy promoting investment. Government consumption is thus less favored than government-financed
investment.
Figure 2 also illustrates the behavior of the investment rate over the past decade. It has averaged
around 40% so that a large portion of it has been financed by domestic saving. Both households
and government have been generating a positive gap between saving and investment while firms have
run a large deficit. This is despite the fact that there is a high degree of financing by enterprise
retained earnings. Investment of non-financial enterprises has come from own savings (from retained
earnings), government capital transfers, bank loans, and FDI.
Figure 1 illustrates how important FDI has been in financing firm investment: most inflows into
China since the early 1980s have been in the form of FDI. As noted by Prasad and Wei (2005), China
accounts for 60 percent of FDI going to emerging markets.
Fact 2: Manufacturing wages are low relative to international levels but high relative
to rural levels
The popular press has made much of the fact that wages in China are uncommonly low. Recent
work by Banister (2005) now makes it possible to compare hourly compensation rates between China
and other economies for the year 2002. Banister estimates that the average hourly compensation of
China’s manufacturing workers was 57 cents in 2002. The hourly manufacturing wage was $0.95 in
cities while it was only $0.41 in rural area. As shown in Table 2, this is 3% of the equivalent American
wage. Even in comparison to emerging Asian markets, the Chinese wage seems unusually low.
Although the manufacturing wage is very low, it has risen in real terms. This urban wage however,
remains significantly higher than compensation in rural areas. Table 3 illustrates this point: the
urban-rural income gap has been rising steadily since the late 1980s.

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Fact 3: China’s agricultural sector has a large reserve of surplus labor which drives
internal migration
There is a wide range of views on the size of rural surplus labor in China. One of the most cited
views (Banister (2005), Brooks and Tao (2003)) estimates that 100 to 200 million surplus workers
live in China’s countryside. As noted in Banister and Taylor (1989), this range of estimates comes
from comparing actual and required employment. Required employment is computed using some
productivity measure in a benchmark year (cultivated acreage per worker or labor requirements per
crop weighted by total acreage per crop). The OECD (2002) estimates on rural hidden unemploy-
ment range from 150-275 million, depending on the benchmark adopted (the exact proportion of
GDP contribution per worker in nonagricultural jobs). The Ministry of Agriculture estimates rural
underemployment at about 150 million people.
Others have estimated surplus labor using measured unemployment. This is problematic because
multiple existing measures and definitions make it difficult to ascertain the exact level of the unem-
ployment rate in China3. As detailed in Brooks and Tao (2003), the measure of registered unemployed
workers provides a misleading measure according to International Labor Organization guidelines be-
cause the distinction between unemployed and underemployed is not clearly drawn. The authors
report that another measure of unemployment more consistent with ILO guidelines is the difference
between the labor force (the sum of the employed and unemployed) and employment published by
the National Bureau of Statistics (NBS) from the quarterly labor force survey. Unemployment, ac-
cording to this measure, was 2% of total labor force in 2002. For their part, Giles, Park and Zhang
(2004) estimate the unemployment rate, using data from the 2001 China Urban Labor Survey and
China 2000 population census, but it concerns urban labor only. They estimate the unemployment
rate among urban permanent residents to be 11.1 percent in September 2002.
In 2004, the labor force in China was approximately 768 million workers4 so that surplus labor using
the range of unemployment rates is between 15 and 85 million. This adds up to between 2% and
11% of the labor force willing to migrate in order to enter the export-oriented high(er)-wage export
sector. We use this estimate to assess the potential length of the transition.
3This difficulty is underscored in Banister (2005) :
“The rural unemployed are completely ignored in the calculation. China’s unemployment rate is based on city data
only. The figure used in the numerator for calculating the unemployment rate is the so-called “urban registered
unemployment”. These are adults living in cities whose permanent population registration (hukou) is located in that
city where they live, who are in the legal working ages, and who are formally registered as unemployed. “Urban
registered unemployment”does not include laid-off workers who are still associated in any formal way with their former
work unit, and does not include workers who have been forced to retire early and does not include in-migrants whose
permanent population registration is outside that city. The denominator of the unemployment rate is the sum of
employed workers in legal working ages whose permanent population registration is in the city where they live plus the
urban registered unemployed.”
She also notes: “China’s NBS and Labor Ministry published a figure of 83 million manufacturing employees in China
of whom 45 million were called rural and 38 million were classified as urban. But these data do not take full account
of the 71 million town and village enterprises (TVE) manufacturing workers reported by the Ministry of Agriculture.
On the basis of the assumption that the 38 million urban and 71 million TVE manufacturing employment categories
are mutually exclusive the total manufacturing employment at year end 2002 was about 109 million. There is evidence
that the official figure of 83 million manufacturing workers excludes millions of migrant manufacturing workers.”
4See the Asian Development Bank key indicators for China.

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Whalley and Zhang (2004) and Zhao (2005) among others argue that the existence of a huge labor
surplus as well as the income gap between urban and rural populations have driven most of the
internal migration in China. Labor mobility is somewhat restricted by the legal restrictions on the
movement of people. The Hukou registration system operates like a domestic passport system (see Au
and Henderson (2002) and references therein). One’s legal residence is usually defined by maternal
residential status. Legal status in a locality entitles the holder to social services (education, health
care, housing, sometimes grain rations), land for farming, job opportunities etc. Changing one’s legal
residence status is difficult. It is possible through the education system (a successful graduate may
move to the city and be given an urban job commensurate with his newly acquired skills) or through
occasional government action that allows urban factories to hire rural workers. ‘Illegal’ migration is
costly: the migrant loses all entitlements associated with residence. The ‘illegal’ migrant can however
work in the informal sector in poor conditions. In later section, we argue that these migration costs
may imply a low level of labor mobility and lengthen the transition.
III. THE MODEL
Consider a small open urban economy populated by identical infinitely-lived households who consume
baskets of differentiated domestic and foreign goods. Domestic goods are produced by monopolis-
tically competitive firms with three inputs: labor, tradable capital and non-tradable capital. Non-
tradable capital must be financed by domestic saving whereas tradable capital can be borrowed on
world markets. This urban economy receives a flow of rural labor whenever the urban wage exceeds
the rural wage.
Domestic firms have access to a standard Cobb-Douglas production function with three inputs: raw
labor L, domestic capital Z and foreign capital K. Domestic capital is capital that cannot be
borrowed internationally whereas foreign capital is available on international capital markets. The
production function is
Yt = F (Kt, Zt, Lt) = atKαtZηt(EtLt)1−α−η
(1)
where 0 < α < 1, 0 < η < 1. Et is the efficiency of labor and grows at a deterministic rate g. at is a
temporary technology shock. Aggregate output in efficiency units is
yt = atkαtzηtl1−α−η
t
where lowercase letters denote variables in efficiency units, i.e. qt = Qt
Et
There are many ways of interpreting Z and K. First, one can think of domestic capital as human
capital and foreign capital as physical capital as in Barro, Mankiw and Sala-i-Martin (1995). Human
capital is inherently more difficult to borrow in international capital markets. A second interpretation
is that K is capital used in the tradable sector whereas Z is capital used in the non-tradable sector.
This is the approach followed by Lane (2001). The production function (1) could then represent the
reduced form of a more complicated model with two sectors. A final option is to define Z as capital
used in the informal sector and K as capital used in the formal sector as suggested by Easterly (1993).
More generally, we think of domestic capital as any type of capital that is hard to borrow against
internationally and which must be saved for domestically (see Verdier (2006)).

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