Dissecting the China Puzzle: Asymmetric Liberalization and Cost Distortion

In this paper we attempt to explain the China Puzzle: coexistence of accelerating economic growth and worsening growth outlook. The root cause lies in China’s unique liberalization approach, i.e., the combination of complete liberalization of product markets and continued distortions in factor markets. Repressed costs of labor, capital, land and resources artificially raise profits of production, increase returns to investment and improve international competitiveness of Chinese products. This is why economic growth is strong, but investment and exports are even stronger. These distortions also contribute to the global imbalances by boosting China’s current account surpluses and capital outflows in forms of foreign exchange reserves. We estimate factor cost distortions for 2000-2009 to gauge the likely magnitudes and cross-year patterns. They provide a reasonable explanation of the movement in economic imbalances. These findings have important policy implications. The government’s efforts to rebalance the economy after 2003 failed because it did not attack the root cause, i.e, the incentive structure. Popular calls for renminbi appreciation might work ineffectively as currency undervaluation is only part of the distortion. The best policy for achieving sustainable growth would be a comprehensive package focusing on liberalization of the factor markets and elimination of cost distortions.