The process of cost normalisation

Fuel price increases are only a small part of the broad cost adjustment currently under way in China. The average wage, for instance, has been growing at close to 20 per cent year on year during the past year (Figure 2.7). Average land prices also rose by more than 15 per cent. The base lending rate is at 7.47 per cent—nearly 1 percentage point higher than a year ago. The real average bank lending rate is already above 9 per cent. Many companies are already feeling the rising cost pressures and some have been forced to close.

Cost distortion has been one important feature of Chinese economic institutions during the reform period. After 1978, the authorities proceeded to rapidly liberalise the goods market. The factor markets, however, remain highly distorted. For instance, policies on labour mobility are still highly restrictive. Land belongs to the public and the government controls its allocation. State-owned entities dominate the allocation of capital. In other words, there are not yet well-developed free markets for production factors. As a result, prices for labour, capital and land are still significantly depressed. According to my rough

Figure 2.7 Growth of land prices and average wages in China, 2001-2008 (per cent per year/year)

Figure 2.7 Growth of land prices and average wages in China, 2001-2008 (per cent per year/year)

Sources: CEIC Data Company and Citi.

Table 2.1 Estimation of China's cost distortion (RMB billion)

Item Cost Key assumption

1. Labour 203 Assuming the new labour law is fully enforced

2. Land 154 Assuming 20 per cent of land sales revenue in 2006

3. Energy 1,632 RMB1,572 billion price difference; RMB60 billion in resource taxes

4. Capital 337 Assuming a 2 percentage-point hike in policy rates after financial liberalisation

5. Environment 1,080 Without considering the RMB287.4 billion per annum maintenance fee

6. Others 429 Equivalent to the amount of export tax rebates in 2006 Total 3,835 15.5 per cent of 2007 GDP

Source: Citi.

estimation, cost distortions probably totalled RMB3,835 billion in 2007—or 15.5 per cent of GDP (Table 2.1).

While cost distortions were not all the result of deliberate policy decisions, they were consistent with the policymakers' clear objective of promoting production and economic growth. By depressing opportunity costs for most factors, distortions in factor markets reduce production costs and ensure high profits in production. This supports continuation of unusual investment growth. Distortions in factor markets, therefore, are like subsidies to producers and investors, which fuel extraordinary growth of the Chinese economy.

The broad production subsidy regime also caused a few problems and risks. First, economic growth becomes increasingly investment dependent because of high profits from production and strong incentives for investment. Second, depressed production costs boost exports and attract foreign direct investment. Third, income distribution deteriorates quickly. Owners of enterprises capture vast production profits. In fact, these have developed into serious risks in China, threatening the sustainability of its rapid growth. This suggests that such a regime of cost distortion cannot continue forever.

In fact, important changes have already begun to take place. The recently introduced Labour Contract Law provides better protection of workers' rights, including their job security and social welfare benefits. Labour costs could rise sharply once the new law is rigorously implemented. Energy prices are still controlled by the State, but the government now intends to grant greater roles for the market mechanisms. Capital costs have also started to rise, as a result of the tightening of domestic liquidity and appreciation of the currency. Finally, the authorities have stepped up efforts to protect the environment, responding to the recent sharp deterioration of water, land and air quality.

This is what I describe as cost normalisation. The whole process could take decades to complete, but rises in production costs could again add pressure to growth and inflation.

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