Wednesday, December 3, 2008

Building a nation demands more than steel and concrete

ZHIWU CHEN, From Wednesday's Globe and Mail - November 26, 2008

As we digest the implications of China's $586-billion (U.S.) stimulus plan, it is intriguing to ponder why Beijing chooses infrastructure, buildings, and big projects every time growth needs a boost. Should, or can, it achieve long-term growth only by adding physical structures? If and when the time comes to pause or change course, will China's existing political-economic institutions accommodate such a transformation?

During a recent trip to Brazil, my taxi driver complained about Sao Paulo's bumpy streets and highways. I responded, "I thought high oil and iron ore prices had made Brazil boom ... Why hasn't Brazil spent more on its infrastructure?"

He replied, "The Brazilian economy has been doing well. But, whenever the government has extra money, President Lula likes to give tax rebates and subsidies to people, instead of using it on the roads."

"Well," I said, "Brazil is a democracy. Imagine you were Lula and had $18-billion at your disposal. Would you rather spend it on highways, or give each Brazilian $100?"

"I guess, give it to the people, just to win more votes."

In China, the government is not elected, so winning more votes is not part of the calculation, and returning money to the people is never the choice. The government doesn't just spend it, but always seems to favour tangible things such as skyscrapers, fancy government buildings, highways, and big industrial projects.

This partly explains not only why democracies such as India and Brazil lag behind China in infrastructure, but also why China is focusing its new stimulus package on transport systems (railroad projects alone will receive more than half of the $586-billion stimulus). In a non-democracy, officials are held accountable to their superiors, not to voters. And for one's superiors, tangible projects are the easiest to recognize.

Indeed, while China's new stimulus plan overwhelmingly emphasizes infrastructure, it gives short shrift to social programs, such as health care and education, even though they can reduce household saving pressure and increase private consumption.

This type of spending structure is nothing new to China. In 2007, government expenditure on health care, social security, and unemployment welfare programs totalled about $88-billion, or 15 per cent of the fiscal budget, and 2.4 per cent of GDP (far below the typical percentage in both developed and developing democracies). Brazil's government spends 4.7 per cent of GDP on health care alone. China's government expenditure on education is approximately 3 per cent of GDP, compared to 5.4 per cent in Brazil.

Due to the lack of public oversight on government budgeting, China's political system is especially biased to favour big physical projects, and, through taxation and state ownership, the government maintains almost full control over much national income and wealth, maximizing the impact of this bias. The wonderful Olympic sites in Beijing were no accident, but rather a result of the system.

Taxation power is hardly checked by the National People's Congress or the media. As a result, from 1995 to 2007, inflation-adjusted government fiscal revenue increased 5.7 times. In contrast, over the same period, the cumulative increase was 1.6 times for urban residents' per capita disposable income and 1.2 times for rural peasants' per capita income. So, China's "socialism with Chinese characteristics" is an economy where an increasing share of national income goes to the state.

Despite privatization, there are roughly 119,000 state-owned enterprises today, with a book value of about $4-trillion. State-owned land is valued at more than $7-trillion. Combined, these state-owned assets total almost three-quarters of China's national productive wealth.

With the state owning so much, most of the gains in asset values experienced over the past 30 years have gone into the government's coffers. When most households own no productive assets, they cannot share any of the asset appreciation or property income. For most citizens, wages are the only source of income. But wages have grown at a far slower pace than GDP. No wonder domestic consumption cannot grow in a manner commensurate with GDP.

Transforming China from an export-driven economy to one that relies on domestic consumption requires two fundamental reforms. First, ownership rights to the remaining state assets should be distributed equally to China's 1.3 billion citizens. This can be done by putting these assets into national wealth funds and distributing the funds' shares to citizens at no cost.

Second, the government budgeting process must be opened up through both public hearings in the national legislature and public participation via the media. Such increased accountability will shift government spending toward programs related to people's needs and away from physical structures.

Without such structural reforms or returning fiscal surpluses to families through tax cuts and rebates, government investment-based stimulus efforts can provide, at best, a short-term economic boost. They cannot transform China's export- and investment-oriented political-economic system. Indeed, even after the new stimulus package, China will still depend on investment and export for growth.

For 30 years, concentrating resources in the government's hands through state ownership and taxes has served China well. It provided a basis for China's nation-building policy of "Concentrate Resources and Do Big Things."

Today, however, China has decent infrastructure, impressive buildings, and an excessive industrial base. What is missing is sufficient private consumption to power endogenous growth. To correct this, China needs to boost its people's sense of future financial security and affect a rise in private income commensurate with GDP growth. Building a nation demands more than steel and concrete.

Zhiwu Chen is professor of finance at the Yale School of Management.