China, it seems, has avoided the much-feared "hard landing"
following a period of overheating in 2003-04. This may be
partially due to continued local enthusiasm for infrastructure
investment and GDP expansion, which prevented demand from
falling sharply when growth finally slowed down. But
today’s soft landing is also due to the simple
fact that the bubble never became too big in the first place.
Compared to the previous episode of overheating in the early
90s, when the official growth rate jumped to over 14% and
inflation reached 22% in 1994, this time government reacted
much more quickly and effectively to contain the heat. As a
result, the overcapacity created in the investment boom was
minimal, so the clean-up job was straightforward. What this
shows is that, for policy-makers, the imperative is always to
act swiftly to avoid time lags after making the right
While we may all agree on that point, the second lesson from
China’s recent experience of macroeconomic
management is more controversial: China still has to rely on
some direct quantity controls (such as lending ceilings) and
some administrative management (such as "industrial policies"
and land-use approval policies). This might seem contradictory
to market-oriented reforms, and could also lead to some
negative consequences for economic efficiency.
China is on the way to market-oriented transformation. But the
institutional change is a long-term effort, and the transition
may take decades. Over this inevitably long period when
institutions do not yet function fully as a market system, and
many big players in the economy such as state-owned enterprises
and local governments are still insensitive to market-based
policies, measures especially designed for this situation need
to be employed.
The deeper point is that what seems effective in the
"objective" textbook (or developed) world may not be effective
in the emerging market reality. For instance, when there are
still some major players in the economy who contribute to the
overheating and even fail to repay their debt principals, the
effectiveness of interest rate adjustment must be limited.
Short-run macroeconomic management policy is predicated on
institutional fundamentals, although all developing countries
should make long-term efforts to reform their institutions
(including privatization, financial liberalization, development
of the rule of law, etc.) in order to lay down the conditions
that would allow market-based policies to work properly and
Some may argue that the mechanism of business cycles would
resolve all problems and
eventually create a market system. This may be true. But what
kind of cycles are we talking about, and how long and how many
cycles do we need to realize those ultimate goals? With an
inefficient state sector, a fragile financial system, and
minimal capacity of a first generation of private enterprises,
it is so easy for China to run into all kinds of crises and to
be marginalized in this era of globalization.
A 10-year recession in China without job creation and income
growth, as happened in some other developing countries, could
lock the country into an era of poverty, instability and
backwardness for another two centuries. As a latecomer to the
market, why shouldn’t a developing country like
China harness the knowledge of the business cycle reaped from
centuries of world history to avoid its pitfalls and therefore
not repeat the same crises as developed countries experienced
in the past?
Developing countries do not have many advantages aside from
their backwardness as latecomers.
The use of administrative controls may slow down reforms or
strengthen the unreformed old regimes. Such side effects are
not insignificant, and are rightly thought of as additional
costs of economic instability in a transition economy. But if
the opportunity cost, i.e. the probability of economic crisis,
is high, it is still worthwhile.
The real issue here is not whether a country like China should
still use the non-textbook (market economy) means of
macroeconomic management, but if it is making enough effort to
reform during both the boom and bust periods, in order to
create conditions for stability and the effectiveness of
market-based policies. From this perspective, two major
problems can be observed in China: first, reforms slow down
during the boom time, as people often lose the sense of urgency
when profitability improves; second, while non-market measures
appear to work, particularly in times of emergency, people
often forget or ignore the demands of price adjustments as a
parallel measure to manage the dual economy.
China’s is still not a full market economy, but
the market has been developing, and some economic agents in the
economy, such as private businesses and private households,
have become sensitive to the policy variables. That sensitivity
is becoming an increasingly important factor for the economy as
the private sector grows fast. But the Chinese government has
been too slow to "allow" the policy variables (interest rate,
exchange rates, tax rates, etc.) to vary.
Unchanged variables created distortions in a changed world and
then led to protracted instabilities. This even created
problems for the next phase of macroeconomic management. For
instance, because the central bank failed to increase the
interest rate during the boom, it will be short of means to
boost the economy when it turns into recession, because it
lacks the room to cut the rate.
The worrisome sign of overheating again reared its head in the
first half of 2006. But the good news is that there is now more
flexibility in key economic variables. For example, foreign
exchange rate regimes reverted to a managed float, and two
interest rate hikes occurred within four months (compared to
once in two years during the 2003-04 period).
More reforms have also been on the way – the
securities market finally started reflecting the changes in the
macroeconomic climate after two years of efforts to make
non-tradable shares tradable; and banking sector reforms are
gaining momentum with first-stage outcomes.
All this may improve China’s economic performance
in the next stages of development and reduce reliance on old
policy instruments. But still, a dual-track policy operation
should be and will be with us for quite a while, as
China’s is likely to remain a dual economy for a
long time to come.
For developing countries, vulnerability is sometimes associated
with being too eager to adopt all the good things that have
been created and seem wonderful in developed countries (not
only the macroeconomic policies, but other things like social
policies and the welfare system, for instance). These are goods
that should be pursued as a long-term goal, but they may not
yet be beneficial for China as the conditions for their success
are still not yet in place.
Fan Gang is professor of economics at Peking University and
Chinese Academy of Social Sciences, and director of the
National Economic Research Institute, China Reform Foundation