China vs. India: A Policy Memo

Today we see many developing countries advancing their economies through reform policy designed to stimulate economic growth.  There are two different viewpoints as to how government policy can best promote growth in foreign countries.  Easterly and Shleifer hold that free market reforms are key and should be emphasized, while government should work to eliminate any policies that get in the way of the free market.  On the other hand, Hausmann sees government having a larger role in these policy reforms.  He argues that while free market reforms are important, they do not tell the entire story, and that unorthodox but creative government solutions can often prove even more important than free market forces. 

Prior to the industrial revolution, China led the world towards advancement in almost every industry.  However, with the transition from largely manual to more mechanized economies, Western Europe and the United States soon surpassed China.   But in the late 1970’s the fortunes of the Chinese seemed to turn once again -- and China’s progress has not slowed since that time. China today boasts one of the highest GDPs in the world, second only to that of the United States (and likely to overtake the US’s within the next decade).   China seems to have followed the Hausmann approach of using government policy to stimulate economic growth.  Free market reforms are of some importance, as Hausmann says, and we can see that China has made some of these, lifting many existing trade barriers and allowing much foreign investment that has made western economies heavily dependent on China.  However, as Hausmann argues, these free market reforms are only a small piece of the picture in terms of how a country can really develop economically, and this is especially the case with China.

The real driver of China’s growth has been a series of policy reforms implemented by the government.  One key reform has been the change in the agricultural sector.  Up until the late 70’s, agriculture consumed over 70% of the Chinese work force.  China has managed to mechanize much of its agricultural industry, making it much more efficient, such that today less than 50% of the work force is in the agricultural sector – yet with agricultural output higher than ever (and continuing to grow). And by lowering the labor input required for agriculture, China has been able to reallocate large numbers of workers to the industrial sector, boosting output by a large margin.  As a result, Chinese manufacturing, which was very limited prior to 1980, today accounts for over 1/3 of the country’s total GDP.

        A second critical Chinese reform policy was the market liberalization, whereby prices were liberalized at the margin.  Prior to introducing this policy, companies had to sell all of their produce at government-set prices.  The reform set up a “dual track” system: enterprises continued to sell their “quota” production at the government-set prices, but were allowed them to sell any surplus over their quota at market price.  Eventually, the inefficiency of the government-set prices was recognized, and the “dual track” system was transformed into a “single track” market system.

        In addition to the change from government-set to market price, another set of reforms was introduced around the concept of township and village enterprises “TVEs.”  The majority of these TVEs were set up during the reform period [what years?] as local government-owned businesses, and by the mid-80s they employed over 30% of the labor force in certain Chinese provinces.  TVEs provided local governments with great sources of revenue and avoided many of the problems and challenges faced by privately-owned enterprises at the time.  In the mid-90’s, as governments found that it was too costly for them to run the TVEs themselves, another series of reforms was introduced, privatizing many of the TVEs and at the same time lifting many restrictions of private entities. However, local governments still retained a fee of total sales and so they were able to keep high revenues.

        In India we see government reforms that more closely emulate the strategy proposed by Shleifer and Easterly.  The main drivers of India’s (much more modest) economic growth are less creative government policies than basic free market reforms.  In the 1970s-1990s the Indian government reduced the number of sectors subject to licensing laws, lowered tariffs dramatically, lowered and eventually eliminated quotas on imports, and in 1991 undertook significant deregulation of industry.  India ultimately found it necessary to obtain assistance from the International Monetary Fund, demonstrating how committed the government was to economic reform.  While all of these measures worked well in putting India on the right economic track, India’s GDP remains much smaller than China’s and the gains in total factor productivity are only 1 percent in India over 2.5 percent  in China.  And while China has made huge strides in the agricultural, industrial, and service sectors, India’s primary growth has been much more concentrated in the service industry.   Thus, while both approaches of economic reform appear to have been quite successful in moving the two countries beyond the poverty of 50 years ago, the strategies pursued by China have been much more effective and have produced substantially greater economic benefits for its population.

Nicholas Jared