Work in progress.

It has been estimated that there are 150 million surplus labour in the rural sector waiting to be transferred to non-agricultural industries. Even if China succeeds in transferring 8 million surplus labour a year, the whole process would take 20 years (Wu 2005). Many economists have differing views of how this could be achieved.

According to Wu (2005), there were two main schools of thoughts on how China can go about its urbanization and to absorb more of its surplus rural labour. One school opines that the cities are already overstretched and the best way to accommodate the surplus rural labour is to develop the non-agricultural industries in the rural areas which in time will evolve into small cities. In other words, protagonists of this school of thought see Chinese economy as having a “triple economy structure” comprising of an agriculture sector, a rural industry sector, and an urban sector. The second school of thoughts, on the other hand, sees Chinese economy as having a “dual economic structure”, comprising of only a rural agricultural sector and an urban industrial sector. Protagonists in this school see serious weaknesses of TVEs that are currently scattered in the rural areas.  They consider them inefficient and incapable of generating the agglomeration effect that is critical in driving industrial development. Urban areas, on the other hands, have the necessary infrastructure and amenities for large scale industrial development. Therefore, development should be focused on expansion of the cities to enable these areas to absorb more surplus rural labour.

Recognizing the importance of the migrant workers’ role in and contribution to China’s industrialization effort, the 16^th National Congress of the CPC passed the resolution on “improving the environment for the transfer of rural surplus laborers” in October 2003. Among other things, it was determined that the plans for the coordinated development of urbanization and industrialization should include efforts to prepare the rural surplus labour for the migration. Both the education hardware and software needed to be upgraded to ensure that the children in the rural areas have the same starting line as those in the cities. Financial assistance would be provided for students from poor rural family to pursue their tertiary education in the cities. In addition, a system of vocational training had to be put in place to equip the migrant workers with adequate skills. At the same time, besides carrying out reforms to improve the operations of existing TVEs, conditions must be made more conducive for the more entrepreneurial to start their own small and medium enterprises which could in turn create more jobs for other migrant workers. Finally, regulations with regards to residence registration needed to be reformed to ensure that migrant workers with stable jobs and residences in the cities could get to enjoy the same rights and share the same social obligations as the urban folks.

Development of TVEs over the last three decades supports the second school of thought. Many TVEs located in the inland regions failed to develop successfully because, among other factors, their locational disadvantages translated into low efficiency and high costs. On the other hand, over the last three decades, many small towns near the coastal region where TVEs gathered during the 1980s have since evolved into big cities. One good example of such towns was Wenzhou in Zhejiang Province. Indeed, since the start of reform in late 1970s, many small towns had developed rapidly to absorb the surplus rural labour. The number of administrative towns grew from 2,173 at the end of 1978 to 19,210 by the end of 1998. In total, these towns housed a population of 170 million. By the end of 2002, the number of administrative town increased further to 19,811 with a total population of 220 million (Wu 2005).

Also, the Chinese experience shows that planning for urbanization and industrialization need to be better coordinated to ensure the vigorous and orderly development of large, medium, and small cities and small towns as well business enterprises of different ownership forms and sizes. In other words, development should be well balanced to integrate the competitive advantages of villages, towns and cities in order to create and reap maximum benefits from the agglomeration effect generated by an integrated value chain. One particularly important link in this regional value chain is the small towns located near big cities. These small towns are the bridges between the rural areas and the big cities. They have the combined advantages of being near to both the source of an abundant supply of low cost labour (i.e. the rural areas) and the market (i.e. cities) for their products. More importantly, these small towns have room for rapid growth and have the potential to evolve into big cities with foresight and careful planning. Initially, the operations of enterprises located in these small towns can play a supportive role to the enterprises in the city. The low-skill labour intensive works can take place in these small towns while the big cities with limited space but better infrastructure and highly skilled and educated workforce could focus on higher value-add activities.

In short, the implementation of various measures by the early 2000s help to lay the foundations for accelerated transfer of rural surplus labourers to urban non-agricultural industries which underwent phenomenal growth as a result of China’s accession to WTO after the turn of the century.

5.4.1 Challenges in Overcoming the “Three Rural Problems”

Amidst the policy adjustment of increasing prices for agricultural products, agricultural production increased over the years until around mid-1990s when the overall shortages in the past turned into surpluses. The excess supply resulted in falling grain prices especially after 1992 when the government reformed the purchase, marketing, and pricing system of grain. Control over selling prices of grain was lifted in more than 98% of all counties and cities nationwide by the end of 1993. In 1995 and 1996, prices fell again as a results of bumper harvests and again. To protect the farmers, the central government raised the government purchasing price of quota grains by grain by 46.6% in 1994, 29.0% in 1995, and 5.8% in 1996. At the same time, the state grain department was ordered to increase their stockpiling of grain.

In August 1997, the State Council issued the Circular Concerning Unrestricted Purchase of Non-Quota Grain at Protective Price, stipulating the setting up of a grain protective price. According to the circular, the price for quota grain could be no lower than that of the previous year while the price for non-quota grain should be the base price for quota grain. In addition, besides fulfilling the usual commitments of quota purchase, all localities were told to purchase without restriction surplus grain from farmers at protective price. The implementation of this supportive policy resulted not only in increase in grain stock but also operation losses and unpaid bank credit. As of March 1998, outstanding grain loans nationwide were RMB 543 billion and grain operation losses amounted to RMB 214 billion (Zhang, Wang and Li, 1998). Despite government’s supportive efforts, grain prices still fell because of excessive supply. On a year-to-year basis, grain purchasing price dropped by 9.8% in 1997, 3.3% in 1998, and 12.9% in 1999.

Meanwhile, to help the farmers, policy makers continued to seek solutions which would not unduly increased the financial burden of the government. In June 1988, the State Council proposed the implementation of three policies. First, surplus grain would still be purchased without restrictions from the farmers at protective price. Second, the purchase grain would then be sold at a mark-up to ensure that the grain enterprises would not suffer a loss. Finally, purchasing funds lent by the policy bank to grain enterprises should “flow within a closed loop” to ensure that money would flow back to the bank after the sales of the grain stock. In November 1998, the State Council further dictated that grain dealers, distributors and processing enterprises were allowed to purchase grains only from state-owned grain purchasing and storage enterprises. All direct purchases from farmers were forbade. However, under the market economy, the policies could hardly be implemented within an environment of falling prices due to excessive supply. As a result, grain enterprises continued to suffer heavy losses.

The decade of 1990s for the agricultural sector was therefore ironically one of falling prices despite years of bumper harvests. The same patterns of increasing supplies and falling prices were seen in other crops, such as cotton, oil, and sugar too. The falling prices caused by excessive supply led to slower growth of farmers’ income and widening income disparity between urban and rural residents. The plights of the farmers were epitomized as the “three rural problems” (三农问题) – stagnant rural economy, poor rural residents, and backward rural society.

The stagnant rural economy was a result of falling prices. Efforts from the government centers around administrative measures of providing indirect subsidies through stipulating protective pricing and unrestricted purchases of farmers’ surplus grain stock. Despite so, prices continued to fall even in the late 1990s because of excessive supply. The problem of slower income growth was accentuated by rapid rises in tax burdens and expenses. The combination of slower income growth and higher tax burden and expenses translated into poorer farmers who found livelihood increasingly unbearable. Finally, focus on urban industrial sector also resulted in the neglect of the infrastructure development of rural sector, making the rural environment less conducive for expansion of industrial activities.

To improve the livelihood of the farmers in a more fundamental way, the government had to seek a comprehensive solution to the to the “three rural problems”. There were several challenges that needed to be overcome.

To begin with, the government had to find a way to liberalize the grain retail market while not hurting the interest of the farmers during the process. The administrative actions of price support and unrestrictive purchase of surplus grain stock proved not only unhelpful for the farmers but was also financially detrimental to the central government. Increasingly, the efforts of the policy makers gravitated towards marketization of the grain purchase and marketing system. One proposal to achieve the marketization of the system was to fully liberalize the grain purchase and marketing in major producing regions and doing away with the indirect subsidies of unrestricted grain purchase at protective prices. Instead, farmers in these regions could receive direct subsidies from the government.

Another challenge that the government encountered pertained to farmers’ land-use rights. Despite all the benefits of the brought by HRS, the system had its limitations. First, the contract did not offer farmers legal and permanent land-use right. In 1985, all farmers signed a contract lasting for fifteen year. As a result of this great uncertainty, farmers withheld making investments on the land. For example, Agricultural investment of collectives and individuals in rural areas decreased from 15.5% of the total rural investment in 1984 to 11.9% in 1987. In contract, nonagricultural investment rose from 84.5% to 88.1%. The low investment on the land led to declining productivity. Also, the ambiguous property rights restricted free transfer of land-use rights. As a result, larger scale agricultural operations could not be carried out through reorganization. In other words, land use could not be optimized. At the same time, again because of the unclear property rights, many farmers lost their land through forceful requisitions by local officials with no or little compensation. Without land, these farmers lost their means of making a living.

Besides the problems on the use of land, there was also the problem of weak bargaining power of the farmers. During the Cultural Revolution, the supply and marketing cooperatives and credit cooperatives were absorbed into the state sector. Even though the government had officially restored these cooperatives since the beginning of reforms, they had failed to recover their original functions because of changed market conditions. Hence the farmers were greatly disadvantaged when signing contracts to sell their produce to commercial companies which would then market the agricultural products as raw materials or primary products in the national markets. In 1998, for example, 38% of the companies that had contracts with farmers failed to keep to their promises of protective prices when purchasing farmers’ products. In many instances, contract formulation was even incomplete. The uneven negotiation power contributed to depressed earnings for the farmers who in turn became less motivated to increase production.

Finally, the government also needed to address the problems caused by migration of rural surplus labours to the cities. According to Wu (2005), one of the deep-rooted causes of the “three rural problems” was the shortage of agricultural resources, especially land, for the huge rural population. Once the surplus labour was liberated by the contract responsibility system and travelling to work in the cities was no more prohibited, migration of this surplus labour was inevitable. At the start of the reform in 1978, China had 82.1% of its population in the rural agricultural sector.

Migration from rural areas to the cities in search of job reached a historical high in the mid-1980s because of rapid growth of the TVEs. From 1984 to 1988, TVEs absorbed an average of 12 million farmers every year to work in the non-agricultural industries. The figure however dropped to five to six million annually after 1989 in the aftermath of the Tiananmen Incident. Also, the growth of TVEs was beginning to slow down by the late 1980s. Some TVEs were beginning to display ‘SOE symptoms’ as they grew larger and encountered weaknesses similar to these SOE counterparts. By the 1990s, the growth of many TVEs began to slow and many also ended in tight financial straits. The situation was exacerbated by the massive employment caused by SOEs’ layoffs of redundant labour in the second half of 1990s. Furthermore, as a result of the influx of migrants, many cities had been filled to the brink and social amenities had been overstretched to accommodate the new migrants. Hence, the migrants were evolving into not only an economic but also social problem and therefore had to be addressed urgently.

In responses to the various aforementioned problems relating to the rural agricultural sector, the Chinese government adopted various solutions.

In July 2001, the State Council issued the Opinion on Further Deepening Reform of the Grain Circulation System. The document stipulated the liberalization of the grain retail markets of eight provinces and municipalities of major consuming regions, including Zhejiang, Shanghai, Fujian, Guangdong, Hainan, Jiangsu, Beijing, and Tianjin. The administrative order pushed the grain circulation system closer to marketization.

At the same time, experiments of the direct subsidy reform, conducted in September 2002 at selected localities, showed positive results. Not only had the farmer’s income increased, the financial burden on the government was also alleviated. The unrestrained working of the grain market also greatly facilitated the structural adjustment of agricultural production and grain mix. In October 2003 during the Third Plenary Session of the 16^th CCCPC, the Resolution on Issues Regarding the Improvement of the Socialist Market Economic System was approved. The resolution put in official writing the requirements of improving the market system for agricultural products, liberalizing the grain purchasing market, and protecting the interests of grain farmers by direct subsidies instead of indirect subsidy through circulation (Wu 2005).

Next, to encourage farmers to invest in and make better use of the lands, the government extended the duration of the farmland contracts in 1993 for another thirty years. The Land Contract Law was passed in August 2002 by the National People’s Congress. Besides protecting the long term stability of the contract relations, the law stipulated that farmers had the right to transfer the use of the land, of their own free will, with compensation. In addition, farmers are entitled to compensation for lawful requisition of the contracted land. Despite the promulgation of the law, however, there was still frequent reporting of forceful requisition of land by local officials who would then make huge profits by putting the appropriated land to other commercial uses.

To alleviate the financial burden of farmers, the Chinese government also abolished various fees and taxes that worked out to a reduction amounting to 30% of the farmers’ total expenses. At the same time, to enable agencies at the grassroots level to operate with lower revenue collections, organizational reforms were carried out so that a simpler administration with better staffs could better serve the needs of the farmers. Rural democratic reforms were also accelerated to improve the quality of villager’ self-government. To address the issue of the farmers’ weak bargaining power vis-à-vis their commercial middlemen, it was decided during the Third Plenary of the 16^th CCCPC in 2003 that support be given to farmers to develop various market-oriented rural professional cooperative organizations. At the same time, the original supply and marketing cooperatives and credit cooperatives would undergo marketization reform so that a democratic management could be put in place to serve members, not the cadres.

Finally, to address the problem of massive migration of surplus rural labour into the cities, government also began to study issues relating to urbanization. Even though employment growth of rural surplus labour by the TVEs and SOEs was stagnating, activities in the private sector were picking up steam as the export sector expanded rapidly. FDI inflow was beginning to rise during the early 1990s after Deng’s Southern Tour. After 1997, the number of small and medium private enterprises also grew rapidly, encouraged by the aforementioned change in official position towards the non-state sector during the 15^th National Congress of the CPC and the subsequent Amendments to the Constitution of the People’s Republic of China protecting the rights and interests of private businesses. The growth of these non-state enterprises in the non-agricultural sector helped to absorb the surplus labour from the rural sector.

Also, drawing on the urbanization experience of developed countries, the Chinese government recognized that the transfer of rural surplus laborers to nonagricultural industries was not only a basic and inevitable component of industrialization, but also a fundamental approach to improve the living standard of farmers. For the farmers, the migration provides another means of generating non-agricultural income. For the national economy, the migration makes good sense as resources can now be better utilized. Historical experiences in developed countries stand testimonial to the benefits of increasing urbanization of its population. Agricultural population for the United States went down from 50% in 1870 to 30% in 1920 when industrialization was generally completed. By 1985, that figure decreased further to only 2.2%. Another industrial powerhouse, Japan, also had its agricultural population dropped from 70% in 1870 to 5.9% in 1995.

In short, the role of the government was to facilitate, not inhibit, the migration. Hence, the government stepped up efforts on the study of the various modes of urbanizations to find solutions that could be applied to the unique Chinese market and institutional environments.

To begin with, there are disagreements as to whether a bubble even exists.  This is also not the first time that doomsayers earnestly foretell China’s doom and gloom.

This time, however, the doomsayers are not economists backed by empirical data but are hedge fund managers who have enjoyed past successes in exploiting the excesses of irresponsible governments and are now convinced that the Chinese growth is not real but manufactured by the state.  Some have followed up their prediction with the launching of ‘distress China funds’ in anticipation of a possible meltdown of the overheated Chinese economy.

Perhaps, China’s emergence as the world’s second largest economy in 2010 is a more telling indication of how overheated the Chinese economy really is . Given the huge Chinese population, it is not surprising that China’s economy outsized Japan’s. What is shocking is the short span of only five years China took to more than double its economy from 18.3 trillion yuan in 2005 to 39.8 trillion yuan in 2010, especially when the world was embroiled in a major financial crisis followed by a recession during two of those years.

Chinese government had wanted to act as early as 2007 to reduce the economy’s overdependence on investment to drive growth. The outbreak of the global financial crisis, however, not only delayed economic reforms but also worsened the structural imbalances. With the fall in interest rate to 5.31 percent by December 2008 followed by the unleashing of the 4 trillion yuan stimulus, money supply spiked.

Three-quarter of the money for the stimulus came from state banks. Officially, loans amounting to 9.95 trillion yuan and 7.95 trillion yuan were issued in 2009 and 2010 respectively. In reality, actual credit created was much larger as banks evaded credit control by developing a shadow banking system that kept dealings off-balance sheet. In the end, the total social financing which includes loans from all other non-bank sources hit about 15 trillion yuan in 2010, almost double that of total official new lending.

With tight capital outflow controls in place, the credits created could only be used for domestic investments which inevitably led to asset inflation in the housing and stock markets. At the same time, the decline of net export had to be compensated by government investments in order to achieve the growth target of at least 8 percent. An estimated $1.7 trillion have been reportedly loaned, for example, to local state entities. Worse, many of the loans are for projects that may not be commercially viable and are backed by collateral comprising of land with inflated values, raising worries over rising non-performing loans.

In addition, policymakers also have to face with mounting inflationary pressures. While GDP recovered to 10.3 percent by 2010, fixed asset investment also rose by 23.8 percent in 2010 to reach 27.8 trillion yuan or about 70 percent of GDP, fueling inflationary pressures. The inflationary situation was also aggravated by the re-pegging of yuan to the US dollar in 2008, causing China to lose some degree of monetary independence. Its interest rates were kept low, albeit higher than that of the US, and its currency weak. While the undervalued yuan and the relatively higher interest rates attracted inflow of hot money, the high economic growth attracted FDI. Coupled with a sizable net trade surplus, the high capital inflow caused foreign exchange reserves to swell 23 percent in 2009 to reach US$2.4 trillion and another 18.7 percent in 2010 to reach US$2.85 trillion, fueling further concerns over excessive liquidity.

Having said that, while there is truth in the talk that Chinese economy has been put on life-support system since the advent of the Global Financial Crisis, a quick meltdown is far from imminent.

The risk is concentrated particularly in the banking sector because of the relatively underdeveloped financial market. An analyst from Fitch Ratings, for example, estimates that China faces a 60 percent risk of a banking crisis by mid-2013. Chinese regulators, on the other hand, maintain that risk is manageable because home mortgages are backed by sufficient downpayments and the total lending volume is limited. Stress-tests conducted by Chinese regulators show that most banks can withstand up to a 30% drop in housing prices. The non-existence of a loan derivative market also greatly reduces the likelihood of a disaster that parallels the US subprime mortgage crisis.

Meanwhile, tight control over inflows limits the impacts of hot money inflows. Most of the capital inflows are FDIs which cannot be easily withdrawn. What remaining liabilities in the international investment position can be covered more than adequately by China’s foreign exchange reserves. Strict capital outflow controls also reduce the likelihood of capital reversal which has been a key factor triggering crises among the emerging economies.

More importantly, Chinese policymakers are planning or have begun implementing several important structural reforms. To start with, instead of focusing on M2, policymakers plan also to look at total social financing which will allow policymakers to better monitor overall liquidity conditions and curb inflation. Next, interest rate controls are being liberalized so that cost of capital can more accurately reflect market forces as well as borrowers’ risks. To broaden the financial market and provide additional funding sources for enterprises, Chinese policymakers are also encouraging the growth of a bond market which will also help to diversify risks away from the banking sector.

In addition, as part of its efforts to internationalize yuan, China has allowed international trades to be settled using the Chinese currency. Capital outflow controls have also been relaxed to support overseas direct investment efforts of enterprises going global. Meanwhile, Shanghai’s stock exchange plans to start an international board to allow cross listings by foreign companies. Besides allowing foreign companies to raise funds in China, the move also enables Chinese residents to invest directly overseas.

Among other things, these new measures help to deepen and broaden the financial system, diversify risk, moderate excessive liquidity, and ease inflationary pressures.

As for the overheated property market, the effects of recent administrative measures to curb speculation are beginning to show. Many property agents in major cities have downsized as interests in resale properties dissipate. In addition, the injection of 36 million units of subsidized public housing over the next five years will go a long way in moderating prices and cooling speculation in the property market.

More pertinently, even though bubbles may exist in asset markets especially in some first-line cities and that industrial overcapacity looms, the real economy is far from being a bubble and will over time be driven increasingly by internally-driven growth underpinned by rising pace of urbanization. The real challenge is in controlling inflation while allowing rebalancing and restructuring to proceed uninhibited.

In recent years, to nurture the nascent domestic hedge fund industry, Chinese regulators have begun introducing tools such as short selling, margin trading, and stock index futures. However, allowing foreign hedge funds unrestricted access is quite another. To begin with, foreign speculators’ room to maneuver may already be limited. Chinese equity markets are relatively closed to foreign investors who have access to probably only less than 1% of Chinese market capitalization.

Furthermore, China is unlike other emerging economies many of which have only limited means. The Chinese government also has more power than most others in influencing its domestic markets through their control over the local governments, state banks and state-own enterprises. This explains, to a certain extent, why the Chinese government succeeded in pulling a fast recovery when the US government failed.

One should never underestimate the resolve of the Chinese policymakers in defending China’s national interests. Allowing foreign speculators to benefit at the expense of China’s misfortune will put the government in extremely bad light in the eyes of its people. Therefore, expect the already well-honed and crises-seasoned Chinese policymakers to do whatever it takes, including the dishing out of temporary anti-market measures, to constrict destructive market activities. In the end, ‘distress China’ fund managers’ hope of a quick windfall may just fall through.

Perhaps, a surer and welcomed way to profit from China is to find more constructive ways to contribute to the Chinese economy. Opportunities still abound despite the talks of bubbles. The US hedge fund and buy-out group Fortress Investment, for example, plans to team up with a local partner in China to provide housing for the Chinese elderly which will number 260 million by 2020.

Short of that, it’s hard to see how foreign hedge fund managers can have their field day even if their zealous prediction of a Chinese economic meltdown materializes.

Note: An edited version is published in Business Times on April 2, 2011.