HIGH GROWTH, CONTRASTING STORIES: CHINA, INDIA, RUSSIA†

Modernizing China’s Growth Paradigm

By ESWAR S. PRASAD AND RAGHURAM G. RAJAN*

China’s remarkable growth performance overthe last three decades is widely attributed to itsunique development model. A principal elementof this model has been an incremental and ex-perimental approach to reforms, with the reformprocess being guided by some general princi-ples rather than a detailed blueprint. This hasbeen complemented by a dual-track approach,which involves maintaining a planned trackwhile encouraging the development of a markettrack in different areas of the economy, therebyallowing for efficiency gains at the margin with-out creating losers in absolute terms (see Law-rence Lau et al., 2001). This developmentparadigm—with its virtues of flexibility, adapt-ability, and pragmatism in the face of variousconstraints to reform—has served China well,generating high and relatively stable growthover an extended period.

Our main contention in this paper is that thisparadigm, for all its virtues and success so far,may be in need of an overhaul. The dramaticshifts in the structure of China’s economy to-ward a complex, market-oriented one, and itsincreasing integration with the world economy,are likely to expose shortcomings in this ap-proach. Indeed, at its present stage of develop-ment, certain aspects of the incrementalapproach could pose significant risks to the Chi-nese economy. Notwithstanding the constraintsthat still exist due to deficiencies in policy andinstitutional frameworks, and the overhang ofvarious legacy problems, there may now be fewalternatives to bolder and more concerted re-

forms in order to maintain high growth andeconomic stability. This is not to say that adifferent approach is not without its own risks,but we view the traditional approach as increas-ingly untenable and likely to generate greaterrisks of its own. Furthermore, the policy distor-tions required to maintain the old approachcould have adverse welfare consequences,though these may temporarily be masked byhigh growth.

I. Some Context

Of the multiple transitions that China’s econ-omy has been undergoing—from rural to urban,from low income to middle income, etc.—twoare particularly relevant for our discussion.First, China is rapidly moving from a commandeconomy to a private sector–led one, with theprivate sector’s share of GDP now estimated atone-half to two-thirds. This process was set inmotion with the market-oriented reforms insti-tuted in the late 1970s. Unlike in the transitioneconomies of Eastern Europe, however, this hasnot been precipitated by drastic changes to thepolitical system and has, instead, been fosteredby the deliberate goal of moving to a “socialistmarket economy.” Second, from being a rela-tively closed economy before the 1980s (in re-cent history), China has become very open totrade and more integrated into global financialmarkets.

Although these transitions have been activelyencouraged by Chinese policymakers, each hasbrought with it some challenges. The move to amarket-oriented economy has created employ-ment and income uncertainty, and the restruc-turing of state enterprises has contributed torising unemployment. Rising average incomesmask increasing disparities in income, espe-cially between the rural and urban areas, whichare generating political and social tensions. In-creasing integration with the global economy

† Discussants: Arvind Panagariya, Columbia University;Josef Brada, Arizona State University.

* Prasad: Research Department, International MonetaryFund (IMF), 700 19th Street NW, Washington, DC 20431(e-mail: eprasad@imf.org); Rajan: Research Department,International Monetary Fund, 700 19th Street NW, Wash-ington, DC 20431 (e-mail: rrajan@imf.org). The views ex-pressed in this paper are those of the authors and do notnecessarily represent those of the IMF or IMF policy.

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has made China more dependent on externaldemand and more vulnerable to external shocks.

Nevertheless, China’s economy has contin-ued to grow at an impressive clip over the lasttwo decades. More importantly, unlike manyother emerging market economies, China hasnot experienced any crises or other sharpdisruptions to growth during this period. Let ustake a closer look at what is behind this growthperformance and how the different economicpressures have been managed so far.

II. China’s Path to High Growth

We begin by reviewing some of the key mac-roeconomic policies that may be relevant to un-derstanding the contours of China’s growth. TheChinese exchange rate policy has received themost attention recently. The renminbi’s valueagainst the U.S. dollar had been maintained at afixed level since 1995, even during the Asianfinancial crisis when there were strong deprecia-tion pressures, indicating the importance that poli-cymakers attach to this nominal anchor. In July2005, the renminbi was revalued against the U.S.dollar by 2.1 percent and, in principle, its value isnow set with reference to a basket of currencies. Inpractice, however, the renminbi still appears to bepegged to the dollar, with little de facto flexibility.

Whether the maintenance of a fixed exchangerate is part of a mercantilist strategy to promoteexport-led growth has been the subject of in-tense debate recently. In any case, resisting un-derlying pressures for real exchange rateappreciation—coming from China’s high pro-ductivity growth in its traded goods sector rel-ative to that of its trading partners—has fedspeculative inflows in anticipation of eventualrenminbi appreciation. This has led to a surge inthe accumulation of international reserves since2001.

The management of capital flows has been an-other crucial component of macroeconomic pol-icy. Extensive capital controls, along with taxbenefits and other incentives, have been used topromote inward foreign direct investment whileother forms of inflows, especially portfolio debt,have been discouraged (Prasad and Shang-JinWei, 2005). Capital controls have also played animportant role in protecting the banking systemfrom external competition, by restricting the entryof foreign banks and by making it harder to takecapital out of the country. The limited develop-

ment of debt and equity markets means that thestate-owned banking system is effectively the onlyofficial game in town, both for borrowers andsavers.

China’s approach to exchange rate policy andcapital account liberalization may be indicativeof a desire to maintain stability on the domesticand external fronts, while opening up to tradeand financial flows. And the large stock of re-serves resulting from these policies may serveas insurance against vulnerabilities arising froma weak banking system. But there comes a pointwhen the policy distortions needed to maintainthis approach could generate imbalances, im-pose potentially large welfare costs, and them-selves become a source of instability.

The uncertainties engendered by the transi-tion to a market economy, the limited availabil-ity of instruments to borrow against futureincome to finance purchases of major durablegoods, housing, etc., and the lack of interna-tional portfolio diversification opportunitieshave all contributed to high household savings(Marcos Chamon and Prasad, 2006). Financialsystem repression has meant that there are fewalternatives to funneling these savings into de-posits in the state-owned banking system.Households willingly hold bank deposits de-spite the weaknesses of the banking systembecause of implicit deposit insurance providedby the government. This provides abundant li-quidity for banks to expand credit which, be-cause of distorted incentives, largely financesinvestment by state enterprises. State enter-prises that do make profits are not required topay dividends, encouraging them to plow re-tained earnings back into investment. The re-cent investment boom has, thus, been fueled bycheap credit and overoptimistic expectations offuture demand growth in sectors that are doingwell at present. Inflows of speculative capitalthat are testing the exchange rate peg haveadded to the liquidity in the banking system andfurther complicated the control of credit growth.

Certain policy choices intended to maintainmacroeconomic control have thus influenced thecomposition of domestic demand, making invest-ment, rather than private consumption, the mainsource of demand growth. In the last few years,investment has accounted for more than half ofnominal GDP growth and may now amount tonearly 40 percent of GDP. While factor accumu-lation is a time-honored path to higher growth for

332 AEA PAPERS AND PROCEEDINGS MAY 2006

many developing countries, whether such a highlevel of saving, intermediated mainly through aninefficient banking system, can produce long-last-ing welfare gains is a dubious proposition. Thecosts of these inefficiencies are probably ulti-mately borne by depositors, in terms of low realreturns on their savings or through the financingof fiscal transfers to firms and financial institu-tions. The investment boom has also raisedfears of a resurgence of nonperforming loans ifthe economy, or even the few sectors that haveaccounted for much of the recent rise in invest-ment growth, should falter (Morris Goldsteinand Nicholas R. Lardy, 2004).

Financial sector reform and development areclearly crucial priorities for growth and stability.But they cannot be seen in isolation from othermacroeconomic policies, including exchange rateflexibility. Indeed, the discussion above suggeststhat arguments about whether, and by how much,the renminbi is undervalued may not be the rightway to frame the main issue about China’s ex-change rate regime. What is essential is that Chinaintroduce greater flexibility in its exchange rate,which would give it a more independent monetarypolicy and also allow the exchange rate to play arole in correcting external imbalances. It wouldalso remove one of the hindrances to bankingsector reform, since a fixed exchange rate reducesthe central bank’s ability to use market instru-ments such as interest rates to guide credit growth,and instead perpetuates a reliance on administra-tive measures, vitiating efforts to make the bank-ing system more commercially oriented. In addition,by making capital account liberalization (a statedmedium-term objective of the government) lessrisky and by creating incentives to develop fi-nancial products to hedge foreign exchange risk,a flexible exchange rate could help stimulatebroader financial market development as well.

Such policy shifts would help rebalancegrowth toward self-sustaining domestic demandand tilt domestic demand itself toward privateconsumption and away from investment. Afterall, it is ultimately consumption, rather thaninvestment or even GDP, that is a better mea-sure of economic welfare over the long term.

III. Approaches to Reform

In discussing policy choices, it is important torecognize that Chinese policymakers are oper-ating in a difficult environment with numerous

institutional deficiencies, including a weak legalframework, poor governance, and economicdata of dubious quality. Furthermore, local gov-ernments at the provincial and lower levels havesignificant autonomy in economic matters.Given the leadership’s objective of maintainingpolitical and social cohesion and stability, thesemake the process of undertaking reforms a high-wire balancing act.

In view of these constraints, China has typi-cally taken the approach of instituting reformsin an incremental manner. This has meant eithertaking small steps or confining reform experi-ments to specific provinces. An obvious exam-ple is the very modest first step recently takentoward the longer-term goal of exchange rateflexibility. Similarly, tax reforms are generallyfirst instituted in one or two provinces; the ex-perience is then carefully studied before rollingout a suitably revised nationwide version of thereform. Such experiences can be used to fine-tune reform strategies, while compensating los-ers from reforms through other redistributivemeans.

The learning-by-doing approach to reformhas a number of advantages. In a second-bestworld with multiple distortions, where the ef-fects of individual policy reforms can be unpre-dictable, it reduces the cost of policy errors anduncertain outcomes in the reform process. Italso gives policymakers a clearer sense of thepolitical and social pressures that could arise inopposition to such reforms, allowing those pres-sures to be tackled more effectively when thereforms are instituted at a broader level. Forinstance, the authorities have been willing towithstand external political pressures while theyassess the real impacts of the first step towardexchange rate flexibility, and use this assess-ment to overcome domestic concerns about thepossible adverse employment and growth ef-fects of this move.

There are three potential limitations to theincremental approach, however, as China’seconomy becomes more developed and com-plex. First, some critical reforms, especiallythose related to broad macroeconomic issuessuch as exchange rate flexibility or capital ac-count liberalization, cannot be isolated to spe-cific geographical areas or sections of theeconomy. Second, as the economy becomesmore sophisticated, factors become more mobileand more able to take advantage of distortions.

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This implies that doing nothing, or very little,carries with it the risk of being overwhelmed bythese mobile factors. For instance, additionalsmall moves toward exchange rate flexibilitycould increase speculative inflows in anticipa-tion of further revaluations, thereby furthercomplicating the conduct of domestic monetarypolicy.

Third, and perhaps most importantly, Chinahas reached a stage of development at whichmany key reforms are unavoidably intercon-nected. Restructuring of the banking sectorwould proceed better if state enterprises werereformed and implicit pressures for state banksto continue providing cheap capital to state en-terprises were eliminated. But reform of thestate enterprises would mean more unemploy-ment which, in the absence of progress toward arobust social safety net, could create social ten-sions.1 Similarly, as noted earlier, exchange rateflexibility is important for financial sector re-forms and overall macroeconomic management.

In short, it may become increasingly difficultto undertake individual reforms in isolation, andthe traditional incremental approach to reformmay not work quite as well given where Chinastands in its development process, with a largeand vibrant private sector and strong linkages tothe world economy. Experimentation may alsobe more difficult, as both national and localreforms will have to be undertaken simulta-neously, and with a magnitude that prevents theforces of arbitrage from taking over and negat-ing the effects of the reforms.

IV. Timing and Priorities

While the Chinese economy may remain re-silient to most shocks, the move toward a mar-ket economy has set in motion forces that willbe increasingly difficult to control. An incre-mental approach can worsen the risks that areinvariably associated with the transition to amarket-oriented system. For instance, in the ab-sence of root and branch reform of the financialsector, freeing up the banking system, whilethere continues to be implicit government insur-ance of bank deposits, could generate severemoral hazard problems that may lead to a re-

surgence of nonperforming loans. At the sametime, a gradualist approach can potentially havecosts of its own by perpetuating existing inef-ficiencies and worsening legacy problems.

There is also the more practical considerationthat it may become increasingly difficult to keepa tight lid on certain parts of the economy. Aprime example is that capital controls are be-coming more porous as domestic and interna-tional investors find ways to evade thesecontrols, which has become progressively easierthrough channels such as expanding trade.Maintaining a fixed exchange rate, while thecapital account becomes more open, can be adangerous combination (Barry Eichengreen,2004; Prasad et al., 2005). But exchange rateflexibility without a well-defined alternativenominal anchor poses risks of instability as well.

Theory and experience from around theworld suggest that anchoring monetary policywith an explicit long-run, low-inflation objec-tive would be the most reliable way for thePeople’s Bank of China (PBC) to tie downinflation expectations and, thereby, to stabilizedomestic inflation and employment againstmacroeconomic shocks (Marvin Goodfriendand Prasad, 2006). A flexible exchange rate andinstrument independence for the PBC are essen-tial for this monetary framework to function welland contribute to macroeconomic and financialstability, and in turn to provide a favorable envi-ronment for high output and employment growth.

Financial sector reform is indeed a core pri-ority, as the authorities well recognize. This willnecessitate making the state banks more effi-cient financial intermediaries that are driven bycommercial considerations. But it also involvesdeveloping broader financial markets thatwould give firms alternative sources of fundsand provide households with alternative invest-ment opportunities. Such competition wouldhelp spur the banking system’s reform efforts.

The financial sector is also one of the keysectors in which a difficult balance will need tobe struck between picking up the pace of re-forms and not getting too far ahead of institu-tional constraints. Continued interest rateliberalization, for instance, is important for thebanking system to function efficiently. But anall-out sprint toward full liberalization withoutadequate regulatory and supervisory mecha-nisms in place could create perverse incentivesthat could hurt financial system stability.

1 Justin Lin et al. (1998) discuss how state-imposedpolicy burdens, in turn, stymie state enterprise reform.

334 AEA PAPERS AND PROCEEDINGS MAY 2006

Fiscal policy has a role to play in the reformagenda as well, especially in terms of strength-ening the social safety net to reduce the politicaland social costs of market-oriented reforms. Re-orienting some government spending toward es-sential social expenditures, including healthcare and education, and reducing uncertainty onthese fronts may help give households the con-fidence to increase consumption levels (OlivierBlanchard and Francesco Giavazzi, 2005). Thelow levels of explicit government deficits andpublic debt provide some room for maneuver inthese areas. Here again, it will be important tomake sure that other reforms, including to thebanking sector, are undertaken apace to avoidthe further buildup of contingent liabilities thatcould put a bind on fiscal policy.

The political economy aspects of reformsalso need to be tackled effectively. Constitu-encies that favor the current system, becauseit generates rents for them, can be effective atblocking reforms. But the current period ofhigh growth and low inflation provides anopportunity to counter these forces, by mak-ing available resources that could helpbroaden the dual-track approach to reform,allowing more of the economy to be openedup to market forces, while weaning the rest ofthe economy from implicit or explicit statesupport. This could go in tandem with thefurther opening up of the economy to externalinfluences, which could create coalitions forreform.

V. Final Remarks

One can only admire the economic progressthat China has achieved in the last three de-cades. But there is much work to be done tomake the economy resilient to large shocks, toensure the sustainability of its growth, and totranslate this growth into corresponding im-provements in the economic welfare of its citi-zens. One important lesson from theexperiences of other countries is that periodsof high growth can sometimes mask deepunderlying problems. At the same time, fa-vorable domestic and external circumstancesmay provide an excellent— but possibly nar-row—window of opportunity for tacklingdeep-rooted problems without causing mucheconomic disruption. For one, sustained capitalinflows and appreciation pressures on the ex-

change rate may make it easier to manage themove toward greater exchange rate flexibility.Similarly, the current state of low inflation pro-vides a good environment to consider setting along-run, low-inflation objective as a nominalanchor. And the favorable fiscal position pro-vides some room for rethinking social expendi-ture priorities, particularly on education andhealth care.

We do not want to underplay the difficultbalancing act that Chinese policymakers face.In fact, China may need a twin Goldilocksianoutcome—for each set of reforms to proceed ata reasonably rapid pace and, at the same time,for a broad set of reforms to move along intandem. Chinese policymakers have managedsuch balancing acts well in the past. But, goingforward, it may be harder for them to feel theirway through controlled policy experiments.While broad and significant policy movementwill be more of a leap into the unknown and willcarry with it attendant risks, the risks of notmoving at a sufficient pace and along a broadfront are even greater. Indeed, perhaps the bestway to mitigate the unknowable risks at thecurrent juncture will be, as part of the broadreform agenda, to develop flexible and potentpolicy instruments as well as streamlineddecision-making structures that allow for nim-ble responses to unanticipated develoments. Insum, it may be time to move beyond feeling thestones and, instead, take some bigger steps onthe road to reform.

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