A Chinese Investment

By Eric Swanson

    Today, China is the world’s fastest growing economy.  Many investors have chosen to take risk into purchasing financial stocks and capital within China with the hopes of gaining some of that quick growth.  It has even been forecasted that by 2050, China will usurp the United States as the world's largest economy.  However, are high GDP growth rates the only measure of a good and stable economy for investors to be confident in gaining a good return?  To evaluate the answer to this question, many considerations must be taken into account.  The events leading up to such fast growth of the economy must be investigated to ensure that growth is based upon sound fundamental economic growth models.  Besides a sound foundation, China will need to have some comparative advantages over other nations to justify such large growth.  In addition, China will need to follow macroeconomic models for legitimacy in the economic community.  Lastly, pitfalls within China's economy should be investigated and described to give investors the complete details of this country's financial situation.  Of course, this is only the beginning in understanding the tools needed to evaluate China as a good investment for an investor's portfolio.

The fundamentals for high GDP growth rates were established long before China became a world economic power.  From 1820–1952 China was a declining economy (Maddison, 12).  No investors would remotely dream of looking towards China for economic growth, because there were much more profitable investments that could be obtained in other countries.  America’s economy, during that same period, increased eight fold, Europe increased by four fold, and Japan increased by three fold (Maddison, 12). However, things changed from 1952–1978.  During this period of time, China was considered to be in the Maoist Period.  Mao, the communist leader at that time, led the government on a campaign to increase government investments from 4% of GDP to 16% (Maddison, 12).  According to the Solow-Swan Model of macroeconomics, increasing government investments is the same as increasing savings.  Over the long run, this excited the economy to grow by 80% from where it was in times past (Maddison, 12).  During Mao’s time, he saw GDP growth rates of 4.4% (Maddison, 9).  After 1978, the Reform Period began and ushered in the dramatic growth rates that China has enjoyed until current times.  During this time period, while Japan invested 0.5% in inventories, and Europe even less than that, China took an exponential jump and increased investment in inventories to 6.8% (Maddison, 12). Here again, China used the fundamentals of the Solow-Swan Model of macroeconomics to recognize that increasing investments will increase savings and greatly increase the amount of growth an economy will realize.  In the long run, this increase in investments helped China experience an even larger GDP growth rate than before.  During the Reform period, China enjoyed an increase in its GDP by 2.5 times (Maddison, 12).  One has not seen that large a growth in China since the 12^th and 13^th centuries (Maddison, 12).  This increase in GDP was the result of reaching an average of 7.4% GDP growth during the Reform period (Maddison, 9).  Due to these past measures, China now enjoys what could be considered the best poverty alleviation program in the 20^th century, per capita net income for farming areas increased 239%, while in urban areas per capita net income increased 152% (Woo, 17).  This resulted in an absolute poverty decline in rural areas from 33% in 1978 to 12% in 1990 (Woo, 17).  In addition, China enjoys the 2^nd largest economy in the world.  At the exchange rate of 4.78 Yuan to the dollar in the benchmark year 1990, China’s GDP was $387 billion (Maddison, 9).  However, if one looks at these numbers through PPP, one can find that using 1990 prices China’s GDP is actually at $2.1 trillion.(Maddison, 9)  These incredible numbers are the result of superior fiscal and monetary policy.  This shows that China was based on sound fundamental economic growth models that have led and probably will continue to lead China into higher growth.

These economic policies came at great political cost.  China has been communist for decades, which means that the economy is state controlled.  However, since 1978, China has been easing its governmental control over industries and businesses.  This has formed a strong market economy that has lifted China to the current superiority it so enjoys.  While China is not an absolutely free market economy, it is considered a socialist economy. However, with such tremendous economic prosperity, many believe this will lead to leaner reigns on the market from the government.

Through this socialist economy, China has relished in a long list of comparative advantages over other countries.  The following advantages and policies have helped China grow more recently:

·        China has a very high ratio of domestic investment relative to its GDP.  Right now, China has a savings rate of 40% (NeHru, 140).  This is considerable in its quantative amount, but it is also considerable in how much that amount can aid in China’s long run growth in accordance with the Solow-Swan Model.

·        China has developed into an economy somewhat controlled by the market; therefore, resources are now being able to be used in their most efficient manner, thereby increasing efficiency and productivity (Lees, 59).  It is  a common belief that increasing efficiency, productivity, and technology has an overall increase in the amount of GDP a country will experience.

·        China is very successful in gaining international capital and finances for its growth.  Right now, China is moving to the largest recipient of foreign direct investment among developing nations (Lees, 163).  $40 billion has entered the Chinese economy in the last three years, which has helped to sustain high economic growth rates (Pinto, 105).  In addition, China controls nearly a quarter of the world’s foreign currency reserves (Pinto, 105). This allows China to be in the most fortunate position of being able to raise capital for entrepreneurs to create new forms of wealth, thereby stimulating more growth in the economy.

·        China has the comparative advantage of a highly educated labor intensive work force for low wages.  This can be seen by the fact that 75% of all toys sold in America are made in China.(Pinto, 108)  This is partly the reason for the large inflows of foreign investment: companies are coming in with their money knowing they will be able hire more workers for their money, thereby decreasing costs and increasing production.  This fact is smart for the business man, but is also advantageous for China because it receives new jobs and new money.

·        China has liberalized trade to take advantage of high exports and importing new technologies (Lees, 59).  This can aid in the production of more technologically labor intensive products that can be sold on the international market.

·        Prices have been freed and are no longer fixed or maintained by the government (Lees, 60).  Freedom of prices allows markets to take control and for competition and market forces to reign in profits, maximize efficiency, and stimulate growth.

·        China is experiencing a renewed interdependence with Taiwan and Hong Kong (Lees, 163).  These relationships help stimulate growth and political security through mutual trade.

These advantages have made China more competitive, efficient, and productive

than other developing countries.  If China is able to keep their competitive advantage in these areas, it will continue to experience high growth and allow foreign investment to flow in greater abundance without reservations from investors.

            Macroeconomic models can tell a lot of an economy of a country.  In China the following data is found to be true in GDP growth rates, inflation, and unemployment.

However, regression analysis proves that no relationship can be proven to be statistically significant.

In each of these cases, the   and  do not have a high enough test statistic, nor do they have a low enough p-value to make them statistically significant.  To make these relationships statistically significant, the test statistics would need to be higher than 2 and possess a p-value of about .5.  This fact makes the data very suspicious that the data is false, because the relationships should exist.  In Okun's Law, the Phillips curve, and even the old school Phillips Curve models, there is a relationship between the variables that is significant.  Since the data could be false, we have look into the practice of Chinese reporting methods.  Many errors are found in their reporting practices.  Some of the problems consist of measurement problems, non-accurate reporting, and misrepresentation of new products (Woo, 20).  Since China is a mixed market economy, it is hard to measure the true values of the economy and distinguish between the government's figures and the private figures.  Many times it has been found that the government reported values twice.  In addition, there are many incentives for business managers and politicians to inflate figures because the government rewards increasing figures.  Lastly, business managers have been known to misrepresent new products by valuing the price at its current price instead of its base year price so that inflation is not taken into account.  These factors must be realized when investing in China because if the fundamental models of macroeconomics does not work in the Chinese economy, one must ask them self if the economy can be trusted to give real returns or paper returns.

There are, in addition, a few other reasons to stay vigilant of the negative economic forces working against the growth China experiences.  Fundamentally, the country is undergoing two transitions.  One is from a rural agricultural society to a more urban, industrial one (NeHru, 137).  Secondly, the country faces the transition from a command economy to a market based one (Nehru, 137).  These transitions can have dramatic effects on the economy. 

            The reason China experiences such large unemployment is of course not due to economic downturn, but to the transition from an agricultural society to an industrial society.  This transition increases unemployment in four ways.  Employment creation has not been able to keep pace with the increase in labor force ("Improve").  Though employment growth is high, it is important to remember that China has the largest concentration of people on earth, and the population growth rate far exceeds the employment growth rate.  Secondly, the flood of new, higher paying jobs in urban areas has brought waves of individuals into the city from farming areas to fill those jobs ("Improve").    However, the waves have been so large that individuals who go to the city for work are not necessarily able to find any jobs.  Thirdly, since China has moved more to a market driven economy, the government can not control the surplus labor it would employ ("Improve").    Since China has decreased the number of state owned industries, China's government has had to decrease the amount of programs and jobs that gave citizens income security. This has resulted in unemployment for reasons of market efficiency.  Finally, the swift increase in GDP has not meant increases in employment because many new industries have become more capital intensive rather than labor intensive ("Improve").  These four factors of high unemployment have contributed to the rough transition from an agricultural economy to an industrial economy.

            China is also suffering from very high debt ratios.  Brookings Institute economist Nicholas Lardy believes that by the end of 2002 outstanding loans will total 135% of China's GDP, which is up from 85% in 1995 ("Poor China").  In addition, loans grew 14%, which is almost double their official growth rate ("Poor China").  These numbers are very staggering and need to be reduced.  Fortunately, the Chinese government's debt is only 23% of GDP, which is quite low, and their assets are quite high ("Poor China").  This will allow China to take on deficit spending if needed in a worst case scenario to bail out banks.  But the reality of it is, with that large amount of money outstanding, it could create tremendous problems if the economy does not grow as fast as expected.

            In addition, there are other miscellaneous problems with the Chinese economy.  China suffers from vast environmental problems that must be addressed (NeHru, 141).  The transition to a market based economy has left negative externalities for the government to regulate and clean up.  This will take resources away from their growing economy to clean up the environment.  Also, China suffers from low productivity in comparison to other countries.  In 1997, China ranked 45^th in comparison to other countries in their GDP per person employed (Pan).  China will need to gain more efficient, technologically capable capital to increase their productive so that more Chinese people will be able to enjoy China's success. 

            Although all of these problems plague China, it does not necessarily mean that China will collapse or that it is a bad investment for the future.  The fact still remains that GDP growth is still high and inflation is low.  China's output grew 8.1% in the last period of 2002, which is still in line with recent historic norms (Wonacott).  As well as consumer prices are down 0.7% in September 2002 as well (Wonacott).  Unemployment is still high at around 10%.(Leggett),  but that is right in line with the historical average of 10 – 11% (Maddison, 15).  So, in a purely economic view, "it would appear possible for China to continue high growth for another three decades," says Dwight H. Perkins ("History", 39).

            With analysis of macroeconomic models and considerations of China's advantages and disadvantages, an investor can know the true health of China's economy.  High growth is a good indicator of a good investment, but all considerations must be taken into account before committing to an investment.  By many accounts, China is a good investment for high returns.

Bibliography

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<http://ifs.apdi.net/imf/logon.aspx>

"Improve access to, and opportunities for, employment."  United Nations. 12 Dec. 2001.

16 Nov. 2002 <http://www.unchina.org/goals/html/obj4_employ.shtml>

"Labor and Social Security Profile." China.org.cn.  12 Nov. 2002. 16 Nov. 2002

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Lees, Francis A. China Superpower. New York: St. Martin's Press, 1997.

Leggett, Karby.  "Opening the Floodgates."  The Wall Street Journal 14 Oct 2002: R5.

Maddison, Angus.  "Chinese Economic Performance in Historical and Comparative

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NeHru, Vikram.  "China Rising: Development Issues and Options for the 21^st Century."

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Woo, Wing Thye.  "Chinese Economic Growth: Sources & Prospects."  The Chinese

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Date this Page was last updated: 12/06/2002