There is an interesting new Federal Reserve paper by Ryan Monarch that looks at some very detailed data on the relationships between US companies and their Chinese suppliers. The main finding is what he calls the inertia in these relationships: US importers tend to be reluctant to change Chinese suppliers, even to get a lower price. And when they do change suppliers, they often go to one that is located not very far from the old one. Here’s the key graphic and the author’s summary:

Two facts are clear from Figure 1. First, there is a significant share of U.S. importers who maintain the same supplier over time. Even though the number of potential exporting choices is increasing over this time period, the share of importers using the same supplier year-to-year is 45.9%. As a benchmark, given that there are an average of 30 Chinese exporters to the U.S. per HS10 product in the data, if importers were choosing their partners randomly each year, the probability of staying would be 1/30, or 3%. Thus path dependence is far higher than would be expected if importers were choosing their supplier randomly. Secondly, among those firms who do choose to switch, approximately one-third of all importers remain in the same city as their original supplier. Using a similar benchmark as above, random exporter selection would imply a 12-13% chance of staying in the same city. Thus there is strong inertia keeping firms in their original city, even if they choose not to use the same supplier as before.

Much of the rest of the paper is about how making it easier for US companies to find trusted new suppliers could lower import prices. I’m more interested in a different angle: what this importer inertia means for the Chinese suppliers and for regional development within China.

Chinese exporters are clustered in the coastal provinces, and for years people have been talking about how rising labor costs in those provinces will push manufacturing inland. The government has embraced this putative trend as a development strategy, building up infrastructure in the inland provinces to lower transport costs and actively encouraging relocation (see for instance this good Reuters piece on the drive to develop textile manufacturing in Xinjiang). Yet despite conventional wisdom and government policy, the inland provinces’ share of Chinese exports is only marginally higher than it was a decade ago.

Inertia helps explain why: existing trade relationships, concentrated in the coastal provinces, change only slowly, and when they do change the geographic shift is likely to be close. The need to maintain customer relationships is thus likely another reason for why manufacturers in the coastal provinces are not in fact so terribly eager to relocate inland. Here is a good observation from a recent Bloomberg article on Guangdong:

By moving elsewhere in China, factories may be able to trim wage bills or gain access to cheaper land, but they lose the concentration of suppliers, logistics and services that Guangdong has built up over 30 years. Gao Dapeng, CEO of Desay SV Automotive Co., which makes car navigation systems in Huizhou, said the overall cost saving of moving to an inland province like Chongqing is only about 10 percent, and it would mean the plant would be hundreds of miles from its suppliers. He said the company is not sure if the relocation is worth that.

It seems like the network effects and economies of scale and scope that China’s coastal provinces have developed are fairly powerful advantages, against which the cheaper labor and cheaper land in inland provinces are not proving as attractive as expected. Or to put it a different way, the cost of switching suppliers remains high, despite policies aimed at reducing it. The same issue could be affecting the lower-wage Asian economies who have been trying to grab export market share from China–which they have, but not as much as some economists expected, as Mark Magnier reports in the WSJ.

The excellent Scholar’s Stage blog reminded me to go through the Asian Productivity Organization’s latest  APO Productivity Databook, a feast of growth accounting data that has been sitting in my to-read pile for a while now. While I also like the consumption chart that Greer chose, my own favorite chart from the report is below; it’s pretty striking.

While it’s possible there are some data problems in their estimation (that’s a pretty steep hockey stick), the direction of the trend is quite plausible. There is plenty of anecdotal evidence that the incentive to substitute capital for labor in China has been quite strong recently. And the government is not shy about using subsidies and other industrial policy to push things even further in that direction. Here is a recent piece from the FT:

Across the manufacturing belt that hugs China’s southern coastline, thousands of factories like Chen’s are turning to automation in a government-backed, robot-driven industrial revolution the likes of which the world has never seen. Since 2013, China has bought more industrial robots each year than any other country, including high-tech manufacturing giants such as Germany, Japan and South Korea. By the end of this year, China will overtake Japan to be the world’s biggest operator of industrial robots, according to the International Federation of Robotics (IFR), an industry lobby group. The pace of disruption in China is “unique in the history of robots,” says Gudrun Litzenberger, general secretary of the IFR.

Yet over the exact period during which it became much more compelling for companies to invest in capital rather than labor, overall investment spending in China nonetheless slowed substantially. The chart below is my estimate of real growth in capital formation in the national accounts (a better if less timely indicator than the monthly fixed-asset investment numbers). Gross investment growth was about 5% in 2015, against an average of 15% over the previous decade.

What’s going on here? How can investment growth be so weak when the incentive to substitute capital for labor is so strong? As for almost all macro questions about China, housing is a big part of the answer (a theme I have hammered on before; see this rant and this more sober post). Residential construction drove a big chunk of that 15% annual growth in the past, but housing now looks like it has moved off the steep part of the S-curve and on to the flatter part. With residential construction stalling out, it’s hard for aggregate investment to grow very fast. It will take a while for robots to compensate for that.

When I first started working on the Chinese economy, most of the research I read compared China to other Asian economies, particularly the “miracle” economies of Japan, South Korea and Taiwan. Grouping these economies together, despite their differences, is fairly easily justified by their exceptionally high growth performance over a long period of time.

But if we think back to the late 1970s and early 1980s, before China had that growth track record, it was not at all obvious that it belonged in the club. South Korea, Japan and the US were allied with the US, and China was, despite its feud with the Soviet Union, still very much part of the international socialist community. The term “transition economies” now conventionally refers only to Eastern Europe and former Soviet Union, and so leaves out by the far biggest example of an economy in transition away from central planning. So how exactly did China end up in the Asian growth miracle club, rather than the transition economy club? Some recent reading has helped me to understand this history better.

The examples of other socialist countries were in fact of great interest in China for a time. In the early years of the reform era, from roughly 1978 to 1985, there was a strong emphasis on establishing that economic reforms were ideologically consistent with socialism. One of the key figures in this effort was Yu Guangyuan, a Marxist theoretician/economist associated with Deng Xiaoping (he passed away in 2013). Yu presented China as one of several socialist countries in the world, all of whom had borrowed the Stalinist system from the USSR, all of whom had encountered problems in applying it to their own conditions, and all of whom were all trying to reform the socialist model. Hungary had had its “Goulash Communism” and Yugoslavia its “workers’ self-management” for years already. This rhetorical strategy emphasized how China was part of the global socialist movement, and how it risked falling behind even smaller socialist countries who were reforming.

Here is Yu on how the example of the Eastern European countries played an important role in early thinking about economic reform, from the preface to a recent anthology of his works:

After World War II, the Communist League of Yugoslavia seized power and proclaimed Yugoslavia a socialist country. Later, the League had differences with Joseph Stalin and was expelled from the socialist camp. Accordingly, the Communist Party of China also refused to recognize Yugoslavia as a socialist country and suspended its relations with the Communist League of Yugoslavia. In the 1950s and 1960s when the Chinese and Soviet parties were engaged in a polemic, we still regarded Yugoslavia as a negative example.

In 1978, a delegation of the Party Central Committee visited Yugoslavia. The delegation was headed by Li Yimang, with me and Qiao Shi being his deputies. Our mission was to conduct field inspections and contacts and then submit a report to the Party Central Committee on the basic conditions of that country and on whether interparty relations should be resumed. Before that, I had contacted some economists from the Soviet Union and Eastern European countries for their views on reform but never conducted any field inspection.

Yugoslavia’s practice left a deep impression on us. From this inspection, we drew a conclusion that socialist countries could have diverse economic models. The delegation submitted a report to the Party Central Committee after the visit. The report held that Stalin tried to impose the Soviet economic system and model on Yugoslavia but Joseph Tito rejected them, which led to a deterioration of the Soviet-Yugolsav relations, and that Yugoslavia was a socialist country and the Communist League of Yugoslavia was a party upholding socialism. Based on this report, the Party Central Committee decided to recognize Yugoslavia as a socialist country and to resume its relations with the Communist League of Yugoslavia. This meant that the Party Central Committee changed its views on the diversity of socialist models…[which] represented an ideological shake-off of the party from the shackles of the Soviet model. …Nevertheless, many people indicated they could not accept the Yugoslav ‘autonomy’ system. In fact, our reform later did not follow that road.

…At the end of 1979, the Party Central Committee dispatched me to head a delegation to visit Hungary for a reform inspection. This inspection deepened our understanding that socialism could have diverse models, and enabled us to have more understanding of many concrete issues in the course of reform.

Yu also sponsored much of the early wave of research into the ideas of Mikhail Bukharin, the theorist behind the mixed-economy model adopted in Russia in the 1920s under the label of the “New Economic Policy” (see this previous post for more). But it is nonetheless the case that once the reform drive got beyond broad political conceptions and into practicalities, China took relatively little from the examples of Hungary, Yugoslavia, Poland and the USSR itself. Rather than restricting itself to models drawn from the international socialist brotherhood, China started looking to countries that were politically more distant but geographically closer.

One of the turning points in this shift is generally held to be the Moganshan conference of August 1982, organized with assistance from the World Bank. Edwin Lim, an early World Bank official in China, recalled the result in a 2005 account (source here):

Other than Adrian Wood and myself, all the other international participants were East European practitioners in Soviet-type reforms, particularly price reforms. Two major conclusions came out of this conference. First was that price reforms of the type attempted in the Soviet Union and Eastern Europe—more price adjustments than fundamental reforms of price-setting mechanisms—were not seen as true reforms. China thus began to look beyond the Soviet Union and Eastern Europe for its reform strategy. By the end of the decade, China was far ahead of the Soviet Union in moving toward a market economy. Second was the consensus among both international and Chinese participants that China simply did not have the margin of error to consider rapid reforms or shock therapy.

Another famous meeting of economists in 1985 helped cement the shift. Again from Lim:

Three years later, following the publication of the second Bank economic report, the question the reformists faced was how to manage a market economy and, particularly, the transition to it from a command economy. To address that question, we organized what has become known in China as the Bashan Boat Conference. The premier attached a great deal of importance to this conference and wanted many of the senior economic policymakers to participate. To ensure their complete attention, the conference was held on a boat (the Bashan) that floated slowly down the Yangtze River through the Three Gorges for seven days. Spouses of the international participants were invited, and each day the boat would dock to allow them to go sightseeing while the conference continued.

The foreign participants to this conference, in addition to Adrian Wood and myself, included Jim Tobin, the Nobel Laureate from Yale, who explained the basic principles of macro-management in a market economy; Sir Alec Cairncross of Oxford, who talked about management of a market economy, particularly the postwar experience of the United Kingdom in dismantling the wartime price control and rationing systems; Otmar Eminger, former president of the Bundesbank, who talked about the role of an independent central bank in macro-management as well as the German experience in dismantling the wartime control economy; Michel Albert, former head of the French planning commission, who talked about indicative planning in a market economy; and Janos Kornai of Hungary, who talked about behavior of a planned economy that may persist in a reformed scenario.

The decisive intervention may have been that of Janos Kornai, judging from how Ezra Vogel summarizes the result:

By the end of the conference, Chinese participants, already doubtful about the appropriateness of Eastern European models for China, were thoroughly convinced that the structural problems in socialist economies—such as the “soft budget constraints” that permitted firms to survive even with low performance and cycles of overproduction—were systemic problems in planning systems. This marked the end of the use of Eastern European reform models and greater acceptance of the role of markets.

If the fellow travelers in Eastern Europe did not have the answers, who did? There were some strong contenders not far away. Here is Vogel again (both quotes are from his Deng Xiaoping and the Transformation of China):

In the early 1980s, while Chinese leaders were exploring the experiences of Eastern Europe and making use of World Bank advisers, they were also studying Japanese experiences. Although Japan was a member of World Bank, Japanese efforts to work with China were generally done bilaterally and were conducted on a larger scale than China’s relations with any other country. Although China was also interested in the Taiwan and South Korea experiences in modernization, mainland China did not have direct relations with them until the late 1980s so their experiences in the early 1980s did not play a major role in shaping Chinese views. …

In the 1980s, Japanese gave more aid and built more industrial plants in China than did citizens from any other country. The Japanese factories built in China set standards by which China measured its progress in achieving efficient industrial production. For the study of modern science, the Chinese looked overwhelmingly to the United States. But more new machinery to build assembly lines in Chinese factories came from Japan than from anywhere else. Prime Minister Ikeda’s income-doubling plan for the 1960s became the inspiration for Deng’s goal of quadrupling the gross value of industrial and agricultural output in the 1980s and 1990s. And from 1974 on, Deng met more delegations from Japan than from any other nation.

By 1985, the idea that China would join the ranks of fast-growing East Asian countries was no longer ludicrous, though not exactly widely accepted. The Harvard economist Dwight Perkins was one of the first to posit that China would follow the high-growth East Asian path and not the less exciting example of the European transition economies. The following passage is from his 1986 book China: Asia’s Next Economic Giant? (note the question mark! a sign of the times):

Reform in the Chinese case means moving closer to at least certain key features of the economic strategy and economic system found elsewhere in East Asia. In concrete terms that means retaining an emphasis on an expanding role for foreign trade, household-based agriculture operating in response to market forces, and a substantially enhanced role for the market in industry subject to continued state guidance but not direct control. … Hungary and Yugoslavia, for example, have achieved reforms in their economic systems that go well beyond those currently in force in China in many respects, but no one contemplates 6 to 8 percent growth rates in GNP in those countries over the next decade or two. … Japan, South Korea, Taiwan and other others have demonstrated that GNP growth rates of 8 percent a year and even higher are feasible in the post-World War II era. In terms of per capita income, level of capital formation, and degree of income inequality China has characteristics similar to those of its East Asian neighbors when they entered into sustained periods of rapid growth.

Ultimately, the reason why China favored Asian over East European models was most likely that those models were more relevant to its conditions on the ground. Despite the political affinity with other socialist states in Europe, China’s economic structure at the start of the reform era was quite different, and more similar to the other Asian economies at the beginning of their growth take-off processes. The classic statement of this argument is a 1994 article by Jeffrey Sachs and Wing Thye Woo, “Structural Factors in the Economic Reforms of China, Eastern Europe, and the Former Soviet Union,” (JSTOR link):

China began reform as a peasant agricultural society, EEFSU as urban and overindustrialized. China faced the classic problem of normal economic development, the transfer of workers from low-productivity agriculture to higher-productivity industry. In EEFSU, the problem is structural adjustment: cutting employment in inefficient and subsidized industry to allow new jobs in efficient industry and services. …Crucially, China’s agricultural workers had nothing to lose, indeed much to gain, from the dismantling of socialism, while much of the industrial and even agricultural work force in EEFSU has plausible fears that dismantling the old system could leave them worse off, at least in the short run.

These days, the differences between China and the other Asian “miracle” growth stories are becoming more apparent–the most important being the continued large role of state-owned enterprises in its economy (the best summary of those similarities and differences is the last chapter of Joe Studwell’s How Asia Works). I wonder if, in this context, comparisons of China to the European “transition economies” will soon start to seem more relevant.

Here is one of the best papers on the Chinese economy I’ve read in a long time–and I read a lot of papers on the Chinese economy. Currently in draft, “A Rebalancing Chinese Economy: Challenges and International Implications” is a systematic explanation of most of the big macro questions about China. The authors are Guonan Ma, an eminent Chinese economist recently retired from the BIS, and Ivan Roberts and Gerard Kelly of the Reserve Bank of Australia.

While there’s a lot to digest in this paper, for this post I want to pull out some of the thoughts about housing. I ranted a while back about how academic economists were ignoring the role of the housing market in driving economic developments in China. This paper by contrast puts housing front and center, and very effectively too. From the conclusion:

We find that conventional analysis understates the role of the household sector in contributing to the high investment share of the economy. Our explanation for the imbalances emphasises the role played by housing market deregulation as one of multiple prolonged positive productivity and demand shocks to the Chinese economy that simultaneously sustained returns to capital, lifted investment and boosted both private and public saving. While recent discussions stress the need to reform financial markets to foster rebalancing, we argue that rebalancing will probably happen anyway as a natural outcome of dwindling income windfalls from worsening demographics, fading positive productivity shocks and maturing housing markets, all of which helped drive the imbalances in the first place.

And some more details from the body of the piece:

The role played by the deregulation of housing markets in China deserves special emphasis. In 1988, the Chinese constitution was amended to legalise the transactions of land use rights, laying the foundation for private home ownership. Throughout the 1980s and 1990s, most of the housing provided by SOEs to their employees was privatised at a discount to the replacement cost. Mortgages were introduced in 1997, and official mortgage rates were cut five times during 1998-2002 to counter the negative consequences of the Asian Financial Crisis.

The deregulation of housing markets saw residential investment rise sharply starting in the early 2000s to almost 16% of GDP currently. This housing boom stimulated huge capacity-building in many related upstream and downstream industries, including steel, cement, glass, household appliances and financial services. Using data from the 2010 input-output tables and more up-to-date data on value-added, Xu et al (2015) estimate that, directly and indirectly, residential housing accounted for 29.4% of GDP growth in 2013.

It is likely that the housing boom simultaneously boosted growth, investment and saving in China while subtracting from net household income (through higher mortgage payments). The rise of private home ownership in the late 1990s boosted incentives to save by households strongly motivated to upgrade their housing and to build up private assets, while generating higher investment. As discussed, the rise in household investment mostly reflected individual investment in residential construction. The property investment booms in the 2000s further boosted land sales proceeds accruing to local Chinese governments, helping to fund investment in infrastructure. At the same time, the steady rise of mortgage loans as a share of total credit (reaching 12% in 2014) implied larger interest payments by home-buyers to financial institutions and a corresponding fall in households’ net property income. In turn, this contributed to the decline in the household share of income in the 1990s and 2000s.

The housing boom increased both sales volumes and prices, lifting corporate earnings and the return to capital across many related industries and helping to underpin strong corporate saving and investment until the late 2000s. In sum, the opening of the housing market can be viewed as a prolonged positive demand shock to the Chinese economy, sustaining returns to capital, boosting investment and lifting both private and public saving at the same time.

The paper is long and somewhat technical in parts, but also conceptually very clear, and the whole thing is very much worth reading. The draft was presented at the Reserve Bank of Australia’s annual conference last week; other draft papers from the conference have also been posted online.