United States

Department

of Agriculture

www.ers.usda.gov

Electronic Outlook Report from the Economic Research Service

Mathew Shane and Fred Gale

Abstract

Few countries have been able to match China’s sustained economic growth,

which has averaged more than 8 percent annually since 1978. The combination of size and rapid growth make China’s economy a major driver in

global economic change. China’s growth has been largely investmentdriven, with investment consuming roughly 40 percent of gross domestic

product. Gains in factor productivity were realized after China abandoned

strict central planning. China’s opening to foreign trade and investment has

also been a key to growth. Conditions suggest that rapid growth will

continue in coming years. However, the Chinese economy faces potentially

unsustainable pressures, including possible currency appreciation, rising

rural-urban inequality, unemployment, banking reforms, and an unusual

combination of inflationary and deflationary tendencies that could slow

China’s growth.

Keywords: China, economic growth, global economy, trade, structural

imbalances, productivity, investment, exchange rate, unemployment,

banking, inflation, gross domestic product, devaluation

Acknowledgments: The authors would like to acknowledge the assistance

of Joy Harwood and Cheryl Christensen in encouraging the development of

this report. Greg Pompelli was instrumental in encouraging us to develop a

set of macroeconomic country outlook reports. This report on China is the

first of that series. David Stallings, Terry Roe, Bryan Lohmar, and Robert

Collender made substantive comments that have improved the quality of the

report. The errors remaining are the responsibility of the authors alone.

The authors are senior economists with the Global Agricultural Markets and

Asia Western Hemisphere Branches, respectively, of the Market and Trade

Economics Division of USDA’s Economic Research Service (ERS).

WRS-04-08

October 2004

China: A Study of 

Dynamic Growth
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China: A Study of Dynamic Growth

Economic Research Service/USDA

Introduction

China’s dynamic economy has one of the highest sustained growth rates in

the 20th century. It has also gone through profound institutional and structural changes. It has been in a long, gradual transition from rigid central

planning toward a more decentralized, market-based economy since initiating economic reforms in 1978. With its accession to the World Trade

Organization in 2001, China is playing an increasingly important role in

world commerce. Foreign investors from around the world have been

attracted to its booming economy. China is a major exporter of manufactured products. It has also become a major player in world markets for oil,

metals and other raw materials, and commodities such as grain, soybeans,

fruits, vegetables, and seafood. 

Gross Domestic Product (GDP) growth averaged more than 8 percent per

year from 1978 to 2002.1 In 2003, China’s GDP grew 9.1 percent and many

sectors grew in excess of 10 percent. Most analysts feel that the current

pace of growth is unsustainable (Heytens and Zebregs). Even the Chinese

government is trying to rein in growth. It set a GDP growth target for 2004

of just 7 percent, but actual growth in the first half was 9.7 percent. 

It is unprecedented for a large country to sustain such a high rate of growth

over two decades. Changes that took decades to achieve in other countries

are occurring in China over the course of just a few years. While China

routinely grows at rates of 7 to 10 percent annually, the United States

achieved its position as the world’s largest economy by sustained growth of

about 3 percent over a period of 100 years.2 Japan’s average growth rate

between 1971 and 1991 was just 3.85 percent. Even the other “Asian

miracle” countries have not grown as fast as China. South Korea, Taiwan,

and Malaysia achieved growth rates between 1971 and 2003 of 7.06, 7.35,

and 6.53 percent, respectively.

China is increasingly important to the global economy. Its share of world

GDP has risen from less than 1 percent in the 1970s to over 4 percent in

2003 (fig. 1). China has the world’s seventh largest economy, behind the

United States, Japan, Germany, the UK, France, and Italy, and some economists estimate that China’s economy is even larger than official statistics

indicate (see box, “How Big Is the Chinese Economy?”). By 2015, if

growth continues as projected, China will be the third largest economy, with

around 6.5 percent of world GDP.3

Why Has China Grown So Fast?

Chinese GDP growth is explained mostly by very high rates of both foreign

and domestic investment, high productivity growth due to major structural

changes, and the opening of its economy to international trade. Conditions

in China suggest that rapid growth will continue in coming years. However,

the Chinese economy faces a number of potentially unsustainable pressures,

including possible currency appreciation, structural imbalances, and an

unusual combination of inflationary and deflationary tendencies that could

become serious obstacles to China’s sustained growth. 

1Using an exponential estimate, the

growth rate over the period was 8.53

percent. However, even using an average annual growth rate, the growth rate

over the period was 8.07 percent.

2Schumpeter (p. 72) asserts that the

U.S. position was achieved with a sustained growth rate of only 2 percent.

3These comparisons are based on a

2000 real dollar exchange rate. If purchasing power parity (PPP) dollars are

used, then China’s economy would be

the second largest. We will comment

more on purchasing power parity

comparisons later in this report.
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How Big is the Chinese Economy?

Great care must be taken in basing international comparisons on Chinese

statistics. Differences in accounting methods and prices, along with

accounting errors, lead to uncertainty.1 Official statistics likely understate

China’s income and living standards, but they may also overstate growth.

Gross Domestic Product (GDP) figures make China the sixth or seventh

largest economy in the world, about the same size as that of Italy. However,

China’s GDP figures may understate the size of its economy. Many

nonmonetary social indicators, such as life expectancy, child mortality, daily

calorie supply, and television sets per capita, place China at a level of development comparable to countries like Thailand, Malaysia, and Brazil, which

have per capita GDP much higher than China’s $1,200 per year.2

Low prices for many consumer goods understate the quantity of goods

produced and the standard of living in China. When converted to dollars at

the official exchange rate, prices of many consumer products, including

food, clothing, household goods, and services, are much lower than prices

of comparable products in the United States. Valuing Chinese goods and

services at U.S. prices, a concept known as purchasing power parity (PPP),

provides a more accurate comparison. GDP is also understated because

important components (land and residential housing rental, defense expenditures, and other government services) are not counted in China’s statistics. 

When adjustments are made for these shortcomings, China's economy ranks

as the world's second-largest, behind only the United States. Per capita

income is still low, but studies conducted in the early 1990s found adjusted

estimates that ranged from three to nine times higher than the official per

capita figure (Wu, 1999, table 1.2). The World Bank's PPP estimate of

China's per capita GDP in 1999 was more than four times the official estimate.

On the other hand, Young (2003) describes numerous factors that overstate

GDP growth.3 It is widely believed that output reported by local government

officials is overstated, since performance evaluations are linked to local

production. Industrial output also tends to be overstated because output

figures are not fully adjusted for inflation. Chinese statisticians revised GDP

accounting methods to include services that were not previously counted in

measures of national output, but did not revise historical series, artificially

inflating GDP growth. After adjusting for these factors, Young finds that

growth is less spectacular than the unadjusted numbers indicate.

1Fred Gale, “China’s Statistics: Are They Reliable?” in Fred Gale, ed., China’s

Food and Agriculture: Issues for the 21st Century, USDA/ERS, AIB-775, April

2002, pp. 50-53.

2Yanrui Wu, China’s Consumer Revolution. Northhampton, MA: Edward Elgar,

1999.

3Alwyn Young. “Gold Into Base Metals: Productivity Growth in the People’s

Republic of China During the Reform Period,” Journal of Political Economy, vol.

111, no. 6, 2003, pp. 1220-61.
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Investment Drives Growth

Much of China’s growth reflects a combination of increased capital investment in machinery, equipment, roads, buildings, and other infrastructure and

increased productivity from more efficient uses of labor and capital.

Economies can grow (increase their output) by adding more factors of

production—–more labor, land, or capital–—or by increasing productivity,

that is, by getting more output from given amounts of labor, land, and

capital. Productivity can be increased by using factors of production more

efficiently, by improving the quality of the basic factors of production (for

example, increasing the skill or education of labor), or by adopting more

advanced technology.4

The relaxation of strict central planning in the late 1970s initiated a period

of productivity gains. Before 1978, in China’s centrally planned economy,

factors of production were producing much below their potential. Production methods, equipment, and machinery were relatively primitive. Each

province was set up as a self-sufficient economy with, for example, its own

food processing, steel, and transportation industries, resulting in redundant

investment and a lack of specialization. Resources were lost to corruption

and bureaucracy, and there was overinvestment in uncompetitive, capitalintensive industries that are not well suited to China’s labor-abundant

economy. Since the 1970s, factors of production have been employed in a

more rational manner. Farmers and factory managers have been allowed to

keep profits, inducing them to get more output from their land, workers,

machines, and equipment. Specialization has also resulted in higher

productivity.

Economic reforms provided a short-term burst of productivity, but a high

rate of investment was necessary to sustain China’s growth rate over more

than two decades.5 China’s rapid growth since 1978 reflects, in part, its

attempt to catch up after decades of economic stagnation under central planning and economic isolation. Long-neglected infrastructure is being

upgraded, and crumbling apartment and office buildings are being replaced

Percent

1971 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03

35

30

25

20

15

5

0

10

Figure 1

China’s spectacular growth translates into an increasing share

of world GDP

United States

China

Japan

Source: USDA’s ERS long-term macroeconomic dataset.

4Denison (1974) introduced the

concept of growth accounting in his

classic work Accounting for United

States Economic Growth, 1929-69.

Others have since refined and expanded the concept, but the underlying

methodology has remained remarkably

constant.

5Eduardo Borensztein and Johathan

D. Ostry. “Accounting for China’s

Growth Performance,” American

Economic Review, vol. 86, no. 2, May

1996, pp. 224-28.
with new structures. Industries are struggling to upgrade production technology and construct state-of-the-art production facilities. China is also

rationalizing investment in new production facilities in nearly every

industry, while scaling back older, uncompetitive state-owned enterprises. 

About two-thirds of China’s gross capital formation6 (GCF) is construction

of infrastructure such as roads, dams, public buildings, and other facilities.

Most of the remainder is spent on machinery and equipment. The majority of

investments enhance the manufacturing sector; agriculture represents about

15 percent of GDP, but only 2 percent of investment. Most “private” investments are made by state-owned or collectively owned enterprises, funded by

internally generated funds or loans from state-owned banks. Foreign investment accounts for about 5 percent of investment in fixed assets. 

Consumption spending contributed to much of China’s early growth

following market-oriented reforms in the early 1980s. Over time, the role of

consumption has declined and the contribution of investment has generally

risen. Since 1978, gross capital formation accounted for an average of 37

percent of GDP, while the share due to consumption expenditures averaged

62 percent (fig. 2). Consumption’s contribution to GDP peaked at about

two-thirds in the early 1980s and fell to 55 percent in 2003. By comparison, consumption accounts for 70 percent of GDP in the United States. The

low level of consumption is the flip side of China’s remarkably high savings

rate, which has provided much of the capital to finance the high rates of

investment.7

Investment accelerated in the early 1990s when China’s leadership signaled

China’s long-term commitment to market-based reforms. GCF reached a

record 43.5 percent of GDP in 1993. Investment was slowed by a bursting

real estate bubble and retrenchment policies aimed at controlling surging

inflation during 1995-96. Subsequently, consumption and exports played an

increasingly important role until the late 1990s, when the effects of the

Asian financial crisis of 1997-99 slowed China’s growth. 

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Figure 2

China’s substantial gross capital formation (investment) contributed

to its high growth rate

-10

0

10

20

30

40

50

60

70

80

1978 82 86 90 94 98 2003

Consumption

Gross capital formation rate

Net exports

Note: Chart shows spending as share of gross domestic product.

Source: China National Bureau of Statistics.

Percent of GDF

10 Shane, Roe, and Gopinath, 1998.

7Franco Modigliani and Shi Larry

Cao. “The Chinese Saving Puzzle and

the Life-Cycle Hypothesis,” Journal

of Economic Literature, vol. 42,

March 2004, pp. 145-70.

6Gross capital formation is the

value of investment in fixed assets and

inventories.
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Beginning in 2000, investment surged again through a combination of

massive government infrastructure spending and investment in manufacturing facilities by both foreign and domestic investors. Preparations to host

the 2008 Olympic Games contributed to a further frenzy of construction

projects. China’s late-2002 accession to the World Trade Organization

spurred many companies, both domestic and multinational, to invest in

China in anticipation of greater market opportunities. Gross capital formation rose sharply from 36.4 percent in 2000 to 43 percent in 2003—nearly

equal to the historical high of 1993 and about 5 percentage points above

China’s average over 1978-2003—as investments in factories, real estate,

roads, and other infrastructure reached unprecedented levels.

A very high GCF rate is a characteristic of the rapidly growing “Asian

miracle” economies. Singapore had an extended period between 1971

and 1985 when its GCF share exceeded 40 percent of GDP. Malaysia

similarly had several years in the mid-1990s where GCF share exceeded

40 percent. In the United States, investment has historically been around

15 to 17 percent of GDP and contributes around 1.2 percentage points of

GDP growth.8 If we use the same assumed input-output ratio in China as

in the United States, the contribution from GCF to overall growth would

be 2.4 percentage points of China’s 8-percent annual growth. However,

comparisons may be misleading, since China’s high rate of investment

occurred in tandem with significant structural change. This has resulted

in a large contribution to growth from capital accumulation of between

4.7 and 6.4 percentage points of annual growth.9 This varied over time,

with early contributions smaller than those in later years. A major

component of this growth was the transfer of labor from agriculture to

industry. Worker productivity rises when laborers move from low-productivity agricultural work to jobs in industry where capital and output per

worker are much higher. 

Labor’s Contribution

China’s abundant supply of labor keeps Chinese wages low, making China

highly competitive in labor-intensive industries. Labor-supply growth was

particularly rapid during the 1980s, when China’s labor force grew by

around 14 million workers per year, an average of 3 percent. This reflected

high birth rates during the 1960s to early 1970s, when China pursued a pronatalist policy. China’s abrupt introduction of the “one-child” population

control policy in the 1970s sharply reduced birth rates, and population

growth fell from 2.5 percent in 1971 to its current 1 percent. As a result,

between 1990 and 2002, China’s annual labor force growth slowed to less

than 1 percent (fig. 3). By comparison, U.S. population and labor force

growth has remained relatively steady, at approximately 1 to 1.5 percent

over this period.

In the United States, labor contributed approximately 40 percent of the realized growth in GDP over the period 1959-91, a contribution of about 1.18

percentage points on average per year.10 According to Denison (1974),

U.S. labor contributed 38.7 percent or 42.8 percent, depending on whether

scale economies are included. However, while China’s labor force growth

rate was approximately 20 percent higher than that of the United States, the

8See: Shane, Roe, and Gopinath

(1998), over the period 1959-91, p. 3,

table 1. Denison (1974) estimates that

capital investment and economies of

scale combined to contribute slightly

more than 30 percent to the growth of

GDP in the United States between

1948 and 1969.

9Heytens and Zebregs (2003), table

2.1, p. 16. The authors estimate the

contributions using Translog and

Cobb-Douglas functions with endogenous or exogenous total factor productivity (TFP) growth.
estimated direct contribution to growth was fairly modest, averaging less

than 1 percentage point per year. 

Improvements in Efficiency and

Total Factor Productivity

Based on the analysis by Heytens and Zebregs, the contribution of efficiency gains and total factor productivity (TFP) to Chinese growth over the

period 1971-1998 was between 2 to 3 percentage points per year.11 This

compares favorably to experience in the United States since about 1995, but

it is substantially higher than the U.S. rate of total factor productivity

growth before that.12 Some studies suggest that China’s productivity

growth is overstated, but it is hard to escape the conclusion that substantial

increases in China’s GDP were derived from sources other than traditional

factors and inputs.13

China’s TFP growth came from a combination of efficiency gains, improved

technology, and improved worker skills. The transition from rigid central

planning to a more market-based economy allowed factors of production to

move to more productive activities. For example, in 1978, 70 percent of

labor was employed in primary industries (agriculture, forestry, fisheries,

and mining), which accounted for just 28 percent of GDP. By 2003, the

primary sector share of employment had fallen to 49 percent. There have

also been improvements in productivity from closing loss-making stateowned enterprises, streamlining government bureaucracy, and improving the

efficiency of enterprises that remained in business. Inflows of capital and

production expertise after China opened its economy to foreign investment

improved productivity. The quality of the labor force improved as education

levels rose. 

Another factor promoting productivity is foreign direct investment (FDI),

which rose from $35 billion in 1990 to over $50 billion in 2002 and 2003.

This has resulted in a substantial inflow of not only capital, but also produc7

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Figure 3

China’s labor force growth rate has been falling faster 

than the U.S. rate

Percent

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1981 86 91 96 2001

China

United States

Note: Chart shows annual percentage growth in labor force.

Source: World Bank, World Development Indicators.

11Total factor productivity is the

percent of gross domestic product that

cannot be accounted for by increases

in factors of production. Thus, an

increase in TFP means that more output is achieved given the same amount

of factors and inputs. 

12Based on Shane et al. (1998),

overall TFP growth in the United

States between 1959 and 1991 averaged 0.4 percent per year.

13Alwyn Young (2003) argues that

Chinese statistics overstate growth.

After making adjustments in the GDP,

investment, and labor data, he finds a

much less striking growth rate in total

factor productivity. Borensztein and

Ostry argue that pre- and post-reform

differences in growth are more modest

when the disastrous Great Leap

Forward and Cultural Revolution periods are excluded from the pre-reform

period.
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tion expertise. Significant transfers of technology to foreign-invested enterprises probably spill over into the general economy and raise total factor

productivity.

The Role of Foreign Trade 

Since the 1980s, China has embraced foreign trade as a key to economic

growth. Tariffs have been slashed, import and export licensing requirements

have been dropped for many products, and most government trading

monopolies have been eliminated. China’s entry to the World Trade Organization was a notable event, although it was preceded by a series of tariff

cuts and other liberalizations during the long period leading to its formal

accession in late 2001. It will take a number of years to fully implement

WTO commitments and realize their impact on trade. 

The most notable impact of China’s opening to trade is the growth of its

export share in many global markets, which has given it the nickname “the

world’s workshop.” While exports have played an important role in China’s

economic resurgence, its imports have also climbed rapidly. China’s trade

balance alternated between small surpluses and deficits until the 1990s.

Since 1990, exports have grown faster than imports and China has had trade

surpluses in all but 1 year from 1990 to 2003. 

China exports labor-intensive manufactured products such as apparel, shoes,

toys, electronics, furniture, and tools. These exports go primarily to the

United States and other developed countries. China is also a major exporter

of many agricultural products, including vegetables, seafood, rice, and corn,

most of which are sold to other Asian countries. China imports raw materials (petroleum, iron ore, rubber, and soybeans), industrial machinery,

equipment, and unassembled components. 

Exports have grown from less than 10 percent of GDP in 1982 to over 30

percent in 2003, underscoring the growing importance of foreign trade (fig.

4). China has greatly benefited by opening its economy. However, this

Figure 4

China has had a trade surplus every year since 1990 except for 1993

2003

0

5

10

15

20

25

30

35

1982 87 92 97

Exports

Imports

Note: Chart shows exports and imports as percentage of gross domestic product.

Source: World Bank World Development Indicators.

Percent of GDF
rising share overstates the contribution of foreign trade to China’s economy,

since much of China’s foreign trade involves the assembly of imported

components and raw materials using designs, engineering, equipment, and

technology outsourced by other countries. China is also becoming increasingly dependent on imported energy and other raw materials to operate its

factories. In many cases, the value-added in China is a small percentage of

an exported product’s final sale value. 

Thus, China’s trade surplus (the value of exports net of imports) is a better

measure of the contribution of foreign trade to the economy. Since 1990, the

trade surplus has averaged about 2 to 3 percent of GDP. The trade surplus

peaked at 4.5 percent in 1997-98 and has fallen to less than 2 percent since

then. In 2003, the value of China’s exports surged by nearly 35 percent, but

its imports grew nearly 40 percent as raw material prices surged. Its trade

surplus of $25 billion amounted to 1.8 percent of GDP in 2003. 

Policymakers and news media have given much attention to China’s

widening trade surplus with the United States, the destination for about onefifth of the value of China’s exports. According to China’s customs statistics, exports to the United States during 2003 surged to $92.5 billion against

imports of $33.8 billion, a surplus of $58.6 billion.14 The surplus with the

United States increased by $30 billion between 2001 and 2003. 

It is less well-known that China’s imports have also surged in recent years.

China’s trade deficit with other trading partners has risen to offset its rising

surplus with the United States and other developed countries. In the first 6

months of 2004, China’s imports surged 40 percent over year-earlier totals

and its overall trade balance tipped into deficit. Imports include machinery

and equipment, instruments, electronic components, fabric, petroleum,

chemicals, steel, copper and other metals, rubber, and animal hides. China is

a net importer of agricultural products from the United States.The largest

agricultural import items from the United States are soybeans, cotton,

animal hides, and animal offal.

In most years, China has a trade surplus in agricultural products.15 It exports

vegetables, fruits, poultry, processed foods, corn, and rice, and imports

soybeans, cotton, wheat, rubber, vegetable oils, animal hides, and animal

offal. However, a surge of imports during 2003 made China a net importer

of agricultural products. The value of agricultural imports rose more than 60

percent in 2003 to $17.4 billion, largely due to sharp increases in both the

quantity and price of soybean and cotton imports (fig. 5). Agricultural

exports were $15.4 billion, leaving China with an agricultural trade deficit

of $2 billion. 

Agriculture is one of the few sectors where China has a deficit in trade with

the United States. U.S. agricultural exports to China surged from $2 billion

in 2002 to $5 billion in 2003, mostly due to rising exports of soybeans and

cotton. The U.S. agricultural trade surplus rose from about $1 billion per

year during 2000-2002 to $3.7 billion during 2003.

China’s foreign trade surplus, in combination with a large influx of foreign

direct investment, has injected significant amounts of foreign currency and

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15Fred Gale and James Hansen,

China’s Exports Outpaced Imports

During WTO Year One, USDA/ERS,

FAU-79-02, August 2003. 

14There are large disparities

between U.S. and Chinese customs

statistics, and U.S. statistics suggest

that China’s trade surplus with the

United States is even larger, at $124

billion. U.S. statistics show imports of

$152.4 billion from China during

2003, over 50 percent higher than

China’s reported exports to the United

States. U.S. exports to China were

reported at $28.4 billion, much closer

to China’s $33.8 billion of reported

imports from the United States.

Statistics for the two countries can differ due to inclusion of transportation

costs and tariffs in the destination

country’s reported value, and to smuggling and differences in counting products that transit through third countries

or territories.
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liquidity into the Chinese economy. China maintains a fixed exchange rate

of 8.28 yuan per dollar through strict controls on capital inflows and

outflows. Its central bank buys up foreign currency entering the country by

selling bonds denominated in yuan to “sterilize” the trade surplus and

prevent the yuan from appreciating against the dollar. Its foreign exchange

reserves rose 25 percent in 2003 to $400 billion, much of it in U.S. Treasury

securities. China’s sustained trade surplus depends on willingness to save its

export earnings (by investing them in dollar-denominated securities) instead

of spending them on imports for consumption. This is the mirror image of

the U.S. trade deficit, which reflects consumption exceeding domestic

production of goods. China’s trade surplus with the United States persists

because China–—like other U.S. trade partners–—is willing to save rather

than spend its earnings from exports to the United States. 

Challenges Facing the Chinese Economy

China has potential for continued rapid growth in the foreseeable future.

The factors that have propelled growth over the past 30 years are still in

place. China’s economy is still a long way from “mature” status where

growth rates tail off. Its per capita income in 2003 was still less than 3

percent of that in the United States in constant 2000 dollars. When adjustments are made for the unusually low prices in China, per capita income at

purchasing power parity (PPP) is about 12 percent of the U.S. average.16

(See box “How Big is the Chinese Economy?”) Growth in the 7 to 8-

percent range per year over the next decade would still leave China with a

per capita income of less than 5 percent in 2000 dollars and less than 20

percent in PPP dollars than that expected for the United States in 2013.

Thus, China will still have very low labor costs compared with other major

countries. While per capita income in South Asia, Indonesia, Vietnam, and

the Philippines is less, none of these countries has the political commitment to facilitate openness to foreign investment in its export industry

sector. As long as China maintains an open attitude toward foreign investment and invests heavily in infrastructure and other capital, it will continue

to grow rapidly.

16A purchasing power parity

exchange rate is derived by comparing

the cost of a common bundle of consumer goods across countries. Since

non-traded goods and goods manufactured in China are very cheap relative

to similar goods in the United States,

the PPP exchange rate would be multiples of the current market exchange

rate. For instance, rents in China

might be a tenth of what they are in

the United States.

Figure 5

China’s agricultural imports and exports, 2002 and 2003

Billion dollars

10.8

17.4

13.0

15.4

2.1 1.0 1.3

5.0

0

2

4

6

8

10

12

14

16

18

20

2002 2003 2002 2003

China's agricultural exports

U.S.

share

Source: Calculations by ERS using China customs statistics and USDA’s

Foreign Agricultural Service trade data system.

China's agricultural imports
However, China’s current growth at rates exceeding 9 percent annually is

likely unsustainable. Limited supplies of raw materials and rising prices for

petroleum, metal ores, coal, and other commodities may slow the country’s

growth. Energy shortages are common in many areas, and China is now a

major oil importer. In 2003, China accounted for 4 percent of world GDP,

but consumed 21 percent of the world’s steel, 31 percent of the world’s coal,

25 percent of the world’s aluminum, and 40 percent of the world’s concrete.

Consumption of raw materials clearly cannot continue to increase at this

pace indefinitely. China’s impact on agricultural commodity markets is felt

most keenly in soybeans and cotton. It accounted for a third of the world’s

cotton use and a fourth of cotton imports in 2003. While it accounted for

only 16 percent of soybean consumption, it was a destination for 32 percent

of all soybean exports.17

Effects of Exchange Rate Policy 

on Economic Growth

China’s exports rely on what may be an unsustainably low fixed exchange

rate. China has maintained its currency at a fixed rate of approximately 8.28

yuan per U.S. dollar since 1997, a rate that some economists suggest is

undervalued by as much as 40 percent.18 A number of Asian countries have

stimulated export-led development by pursuing a policy of an undervalued

real exchange rate.

Although it is difficult to determine an appropriate exchange rate exactly,

several indicators suggest that China’s real exchange rate is undervalued.

The first indicator is China’s substantial trade and current account surplus

since 1995.19 The inflow of foreign currency (e.g., U.S. dollars) resulting

from a trade surplus normally increases the value of the home country’s

currency. China’s central bank has been following a policy of “sterilization” by purchasing foreign currency coming into the country to prevent

this from happening.

Perhaps a more significant indicator is the failure of the current exchange

rate to maintain purchasing power parity between the U.S. dollar and the

yuan. An exchange rate would achieve parity if a dollar could buy the same

amount of goods and services in either country. In fact, Chinese prices of

comparable goods are much lower than U.S. prices when converted at the

official exchange rate. For example, in 2004 fresh pork retail prices in

Beijing averaged about $0.66 per pound, poultry was $0.57 per pound, and

apples $0.16 per pound, converted at the official exchange rate. After

adjusting for differences in quality and service, these prices would still be a

fraction of U.S. retail prices. Valuing Chinese consumption of goods and

services at U.S. prices results in a Purchasing Power Parity per capita

income of $4,400 for 2002 (at 2000 prices), which is 3.67 times the $1,200

per capita income converted at the official exchange rate. Thus, the

exchange rate would have to value the yuan at more than three times (2.25

yuan per dollar) its current value in order to achieve purchasing power

parity. While it may be expected that the current dollar exchange rate and

the PPP exchange rate would differ for developing countries, the ratio of

3.67 is much higher than the average ratio of 2.5 for low-income developing

countries. 

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17By comparison, China has 22 percent of the world’s population.

18There is a range of opinions on

China’s exchange rate. Some economists argue that a removal of capital

controls would lead to outflows of

capital, which would lead to devaluation. China resisted pressure to devalue as recently as the 1997-98 Asian

financial crisis. 

19China’s imports surged in the first

half of 2004, pushing its foreign trade

into deficit. However, a surplus was

expected for the second half of 2004.
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Another factor suggesting undervaluation is China’s extremely low labor

costs. Annual earnings by Chinese manufacturing workers averaged

$1,330 when valued at the official exchange rate in 2003, compared with

$30,000 for U.S. workers.20 Labor costs do not directly translate into

competitive advantage since low labor productivity can offset the cost

savings from lower hourly wages. However, remarkably low Chinese labor

costs, valued at the official exchange rate, are a major factor in allowing

Chinese exporters to sell at prices far below those for comparable goods

produced with U.S. labor. For instance, based on a recent survey of U.S.

furniture stores, furniture manufactured in China can enter the U.S. market

at 25 to 33 percent of the cost of comparable furniture manufactured in the

United States.

The growing bilateral trade surplus with the United States has put substantial pressure on China to revalue its currency. Other countries, frustrated at

losing export markets to China, have also pressured China to appreciate.

However, China resisted pressure to devalue during the 1997-98 Asian

financial crisis when currencies of neighboring countries fell sharply. More

recently, China’s booming exports have prompted accusations from trade

partners and competing nations that it undervalues its currency to maintain

low prices for its exports.

Chinese authorities have resisted calls for appreciating the yuan or floating

the exchange rate. Various news reports indicate officials are considering

eventual movement to a more flexible exchange rate mechanism, such as

tying the yuan to a market basket of currencies, but no definite plans have

been announced.

Chinese authorities may be forced to allow a modest appreciation of 5 to 10

percent to slow down inflows of foreign currency and raw material imports

and prevent overheating of the economy. There have been recent indications

that such a move is at least being considered, if not being planned for

implementation. The latest suggestions are that the currency will be allowed

to float around a band of, say, 5 to 10 percent from its current rate of 8.28

yuan to the dollar.21

Given the importance of China to world trade, a substantial appreciation of

the yuan would have large impacts. Appreciation would raise prices for

China’s exports and erode its dominant position in markets for textiles,

electronics, and other manufactured goods. At the same time, imports

valued in yuan would be cheaper, stimulating China’s imports. China,

already a significant trader in agricultural goods, would become even more

so. The United States, as a major agricultural exporter, would be a main

beneficiary of those increased imports. An appreciation of around 33

percent would reduce China’s exports and increase the volume of imports,

but an appreciation of 5 percent would have only modest impacts. 

Structural Imbalances

China has some serious structural problems that have resulted from the

combination of extraordinarily rapid growth and the transition from a

20China’s earnings were estimated

by dividing total manufacturing earnings by the manufacturing employment published by China’s National

Bureau of Statistics. U.S. earnings

were estimated based on average

hourly earnings in manufacturing

reported by U.S. Bureau of Labor

Statistics, multiplied by an assumed

2,000 hours worked per year. These

calculations do not include nonwage

benefits. There is no adjustment for

differences in productivity.

21For instance, see The Economist

Intelligence Unit, China Country

Profile 2004, March 2004, p. 56.
centrally planned to a market economy. These could lead to economic or

social instability and threaten China’s continued economic growth. 

Troubled Banking System

Nonperforming loans in the Chinese banking system are one of the most

important structural problems. China’s major banks are state-owned and

have historically made loans under government direction to unprofitable

state-owned industries, with little regard for repayment or risk. Many of

these loans were never paid back. The official estimates are that nonperforming loans total around 25 percent of GDP, or $300 billion. However, it

is widely believed that the official number greatly understates the extent of

the problem. Nonperforming loans could exceed 50 percent of GDP, or

more than $600 billion.22

While Chinese banks may be near insolvency, they have little competition

for the savings of Chinese households. The inflow of deposits from China’s

high savings rate has given the banks enough liquidity to continue operating. However, as a WTO member, China must open its domestic market to

foreign banks starting in 2005. If foreign banks attract deposits away from

the Chinese banks, the Chinese banks could become insolvent, leading to a

major financial crisis.

Addressing problems in the banking system is a top priority in China. In

2003, China used $50 billion from its foreign reserves to recapitalize its two

strongest banks and prepare them for stock market listings. Management,

customer service, and risk analysis are being upgraded to compete with

foreign banks. A major bailout and reform of the system of rural credit

cooperatives was also initiated. Chinese banks are also rapidly upgrading

notoriously poor management and customer service to compete with foreign

banks. However, there were continuing concerns that rapid loan growth and

reckless lending during 2004 could lead to even more nonperforming loans

in the future. In response, authorities overseeing Chinese banks raised

reserve requirements and called a moratorium on loans to certain sectors in

an attempt to cool down the economy.

State-Owned Enterprises

A second, and related, structural problem concerns the inefficiencies of

state-owned enterprises, formerly the primary employers in urban China.

SOEs employed 59 percent of urban workers in 1995, but only 27 percent in

2003. They consume much of China’s capital through their historical links

to the state banks and dominance of stock exchanges in China, but they

produce little or even negative return on their capital. Many are poorly

managed and protected from competition. Private enterprises are much more

efficient, but most are excluded from stock exchanges and they have less

access to loans from state-owned banks. Many state-owned enterprises

have been shut down or merged with stronger enterprises, but fears of exacerbating already-serious unemployment problems are a constraint as China

shifts resources to the private sector. 

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22Global Insight. Presentation in

Washington, DC on March 16, 2004,

p. 11.
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Growing Regional Disparities

A third major structural imbalance is the degree to which development has

been concentrated in a few major coastal areas, with less growth occurring

in the rural, central, and western regions. Living standards in some coastal

cities are approaching those of middle income countries, while other cities

lag far behind (fig. 6). In 2003, urban per capita income was more than

three times the rural average, up from twice the rural average during the

1980s (fig. 7). In 2000, China embarked on a “develop the west” campaign

to push both public and private investment into the country’s poorest

western provinces. In 2004, the party and central government leadership

issued a “No. 1 Document” that made increasing rural incomes a top policy

priority. Major policy initiatives in 2004 included a phase-out of agricultural

Per capita income (yuan)

2,500 - 3,400

3,500 - 4,499

4,500 - 6,499

6,500 - 14,000

Figure 6

China’s estimated per capita income by province, 2003

Figure 7

China’s urban and rural real per capita income, 1978-2003

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Urban per capita income Rural per capita income

Urban-rural ratio

Note: Per capita income is deflated using the retail price index and expressed in year 2000

constant yuan.

Source: Calculated by ERS using data from China National Bureau of Statistics.

1978 80 82 84 86 88 90 92 94 96 98 2000 02

Yuan Ratio
taxes and direct subsidies of $1.2 billion to grain producers in 13 of China’s

31 provinces. 

Fiscal Deficits

The boom of recent years has been partially supported by substantial fiscal

deficits. On average, during the decade of the 1990s, China had a fiscal

deficit in excess of 2 percent of GDP. This compares with a current U.S.

fiscal deficit of around 4 percent of GDP. Between 2000 and 2002, China’s

fiscal deficit widened to an average of more than 3.5 percent per year. In

2003, the deficit narrowed, but new spending programs and tax cuts could

expand it. It is possible to sustain a fiscal deficit in the 2 percent of GDP

range for a developing country with excess capacity and low external debt.

However, sustained fiscal deficit in the range of 2 percent of GDP, the

higher range of the early 2000s, would be excessive.

The central government’s fiscal deficit does not include deficits incurred

by local governments. Many rural townships and villages are heavily in

debt or bankrupt. The extent of local government deficits is unknown, but

press reports often include references to difficulties paying teachers and

local government employees. Recent government directives aimed at

helping farmers (reducing local taxes and fees and paying out subsidies

and other benefits to farmers) may put additional financial stress on local

government finances. 

More troubling are potential liabilities, including nonperforming loans held

by state banks and unfunded pension liabilities. Fiscal deficits could eventually lead to inflation if the government prints money to pay pensioners or

bail out banks, state-owned enterprises, and local governments. 

Unemployment Problems

The relatively rapid expansion of China’s labor force has left China’s

economy with an unusual combination of extremely rapid growth and

chronic unemployment problems. The official urban unemployment rate is

in the range of 4 to 5 percent, but large numbers of laid-off workers are not

counted in the statistics because they remain on their employers’ books

although they draw little or no salary. Actual unemployment is much higher,

with a recent estimate of urban unemployment for 2002 of 14 percent.23

More seriously, it is widely recognized that much of China’s rural labor

force is underemployed, engaged only in seasonal agricultural work with

paltry earnings. China has about 2.5 agricultural laborers for every hectare

of arable land. China’s Ministry of Agriculture estimates that rural China

has 150 million surplus workers.24

Many of China’s labor-intensive factories and construction sites are staffed

with migrants from rural areas whose only alternative is to subsist on landholdings that average about 1 acre per person. However, despite the huge

rural-urban migration flows, rural areas still have surplus labor because

China’s household registration system prevents most rural people from

legally moving to cities. At the same time, urban unemployment problems

have been exacerbated by industry restructuring that has closed down or

downsized loss-making state-owned enterprises. Many laid-off workers

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23John Giles, Albert Park, and

Juwei Zhang. “What is China’s True

Unemployment Rate?” Unpublished

paper, February 2004,

http://www.msu.edu/~gilesj/gpz2.pdf.

24“China: Surplus Rural Laborers

Hit 150 Million,” China Xinhua News

Agency, April 8, 2004.
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have been forced into early retirement on minimal pensions or into lowpaying jobs as street vendors or taxi drivers.

China now faces the difficult challenge of simultaneously reducing unemployment problems and raising incomes. Employment must grow by 1

percent annually just to keep up with growth in the labor force. Nonagricultural job growth will have to be even faster to absorb unemployed and

underemployed rural workers. At the same time, Chinese companies are

under pressure to raise worker productivity in order to cut costs and

compete both domestically and internationally. The need to increase worker

productivity induces employers to minimize hiring, which conflicts with the

goal of employment growth.

Inflation or Deflation: Which Is It?

In recent years, China has been viewed by various economists as both a

potential source of deflation in the world economy for manufactured goods

and a source of inflationary pressure for raw materials. Extremely rapid

growth in the range of 8 to 10 percent annually would result in significant

inflationary pressures in most economies as demand for raw materials

outstrips supply. With China such a large part of the world market,

however, this pressure spills over into the international market. Thus

increases in the price of oil and other primary commodities in 2003 and

2004 are a direct result of the increasing demand from China and the

upswing in the United States. During the early 1990s, China did experience

a bout of rapid inflation that peaked in 1996. Officials cooled down the

economy through tighter monetary policy and by ordering state-run banks

to tighten credit availability.

However, between 1997 and 2002, China experienced periods of mild

deflation, with the price level dropping 1 to 3 percent annually (fig. 8).

Agricultural prices fell over this period after reaching historical highs in

1996. Rapid investment in factories and other assets boosted production

capacity, and demand weakened during the Asian financial crisis of 1997-

Figure 8

China’s industrial product prices fell during 5 of the last 7 years

-10

-5

0

5

10

15

20

25

30

1990 92 94 96 98 2000 02

Percent

Note: Calculated from China price index for industrial products when they leave the factory.

Source: China National Bureau of Statistics.
98. Spending by cautious Chinese consumers grew at a relatively slow rate

as saving rates rose. Supply outpaced domestic demand in many industries,

leading to inventory buildups and price wars between rival companies in the

late 1990s. Normally, in a market economy low prices drive firms out of

business or induce them to cut back production. But in China, many

companies keep producing despite chronic losses and unpaid debts because

state-owned banks continue to extend them credit. Many foreign-backed

ventures accept short-term losses because they view China as a potentially

lucrative market in the long-term.

During China’s deflationary period, some observers suggested that China

was a source of deflationary pressure on world prices. Its seemingly boundless supply of low-priced exports was seen as keeping downward pressure

on prices worldwide. Manufacturers in other countries had to maintain

constant prices to stay competitive with Chinese products.

Inflationary pressures started to manifest themselves in late 2003 and 2004

through rapidly rising raw material prices. China’s consumer price index in

April-June 2004 was up 5 percent and the retail price index up 4.1 percent

over year-earlier levels. However, consumer price inflation was confined to

food items. The food component of China’s consumer price index was up

14 percent in June 2004 relative to year-earlier levels. Consumer grain

prices were up 32.0 percent, and meat up 22.1 percent, eggs, 30.3 percent,

and fish 18.5 percent, reflecting rising commodity prices not only in China

but worldwide (table 1). Prices rose sharply for nearly every major raw

material, including petroleum, steel, other metals, and coal. The Chinese

Government became concerned that the economy was overheating, raised

bank reserve requirements, and prepared to tighten money supply growth.

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Table 1—China’s annual inflation rate increase in consumer prices,

by item, June 2004

Annual change in

consumer prices

Percent

Consumer price index, all items 5.0

Consumer price index, by item:

1. Food items 14.0

Grain 32.0

Meat 22.1

Eggs 30.3

Fish 18.5

Vegetables 10.2

Fruit -0.9

2. Tobacco, alcohol 1.5

4. Clothing -1.5

5. Household items -1.4

6. Health -1.4

7. Transport, communication -1.3

8. Recreation, culture 0.7

9. Housing 4.9

Note: Annual percent change in Consumer Price Index from the same month in 2003.

Source: China National Bureau of Statistics.
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Prices of most nonfood consumer products continued to fall, despite

sharply rising raw material prices. In June 2004, Chinese consumer prices

of clothing, household items, health services and products, and transportation were again down 1.3 to 1.5 percent from year-earlier levels (table 1).

Prices for recreation and cultural items were up 0.7 percent, and tobacco

and alcohol registered inflation of just 1.5 percent. Housing was the only

nonfood consumer item with significant inflation, at 4.9 percent over yearearlier levels. Thus, sharply rising raw material prices were still not

reflected in nonfood consumer prices.

Conclusions

China’s economy has grown at rates that are among the highest for any

major country in the 20th century. The Chinese have accomplished this by

moving their highly centrally planned economy toward a decentralized

market economy. Underlying this change and the very high rates of

economic growth are high gross capital formation shares of GDP, which

have exceeded 40 percent in some years, and a flow of direct foreign investment that has brought the added benefit of technology transfer. While it is

clear that a substantial part of the high growth rate is due to overcoming

inefficiencies in the centrally planned economy, the increase is also the

result of significant growth in total factor productivity.

However, serious structural imbalances exist that must be dealt with if

growth is to continue at or near past rates. A substantial burden of nonperforming loans, equal to perhaps as much as 1 year of Chinese GDP, overhangs the banking system. Significant income differentials between rural

and urban areas must be addressed. In spite of the impressive economic

growth rate, high unemployment and underemployment still exist. Finally,

significant international pressure is on China to revalue its arguably undervalued exchange rate. All these factors pose risks for future Chinese

growth. While our central forecast supports continued high growth, uncertainty as to how China will deal with its risk factors tempers that forecast.
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