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In the first decade of the reform period, investment gross fixed capital formation averaged around 28 per cent of GDP. However, investment's share of GDP has since increased consistently, averaging almost 40 per cent in the decade to to stand at 46 per cent in , above the historical peaks experienced in Japan 37 per cent, , South Korea 38 per cent, and Thailand 42 per cent, While high, the significant rise in investment's share of GDP is an experience largely typical for an emerging economy, reflecting the low initial capital stock and large returns to investment Hubbard, Hurley and Sharma, China's extraordinary investment growth over the past three decades has been supported by government policies that have favoured investment and the industrial sector.

Capital has been channelled on favourable terms from savers to large enterprises and SOEs, aiding capital accumulation during the industrialisation process. Furthermore, reforms to property rights allowing private housing in the late s and an incentive structure that encourages local governments to invest heavily in search of rapid economic growth has also contributed to high levels of investment in China. Another factor enabling China to invest to an unprecedented scale is its vast stock of savings, which is high by international standards and has grown considerably over the past few decades.

The rise in saving has been driven by all three sectors of the economy — corporate, household and government Chart 5, Panel B. The household sector is China's largest source of saving, accounting for on average almost half of China's national savings since However, contrary to some perceptions, corporate saving has accounted for most of the increase in China's national savings since China's current growth model, underpinned by high savings and low factor prices that favour investment and exports, has served China well for three decades. However, while China still possesses significant catch-up potential and will continue to benefit from some of the favourable conditions that have driven its economy for some time to come, the benefits are fading, and a number of factors are likely to weigh on growth going forward.

Externally, the favourable conditions that allowed China to yield large gains from 'opening-up' appear to be diminishing. In particular, the outlook for the external environment remains highly uncertain, and with domestic wages on the rise, and growing competition from low cost producers elsewhere, China can no longer depend on exports to the extent it has become accustomed to see Coates, Horton and McNamee, While China has invested on an unprecedented scale over the past three decades, China experienced an even larger rise in its savings.

Domestically this imbalance manifests as a low household consumption share of GDP, while externally, it implies a widening of the current account surplus. The capital intensive nature of growth — underpinned by distortions that favour industrial production over services and household consumption, alongside suppressed wages as a result of the surplus rural labour and relatively weaker import growth — has contributed to large current account surpluses.

But with an external environment unable to absorb the growing production to the extent it used to, the need to adjust to a less export-reliant growth model has intensified. Domestically, the capital intensive nature of growth has contributed to the low household consumption share of GDP, which has fallen by 11 percentage points between and Even though this could stabilise as China exhausts its supply of surplus labour, there remain formidable policy challenges Hubbard, Hurley and Sharma, While there remains significant scope for strong investment growth, there are question marks over the sustainability of current patterns of investment.

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In a remarkably short period of time, aided by distorted factor prices, China has been able to build the infrastructure that high income economies took many more years to build. In the past five years alone, China has built more high-speed rail lines than exist in France Broderick, , and in , China built more residential floor space than exists in Australia Berkelmans and Wang, However, as China approaches the standard of living enjoyed in high income economies, a continuation of these patterns of investment increasingly comes at the risk of overinvestment and excess capacity, with consequent risks to economic stability.

Furthermore, as China's economy matures and approaches the technological frontier, the scope for TFP gains from the adoption and transfer of advanced technologies will begin to fade. These challenges are set against a background of the ageing population and looming exhaustion of surplus rural labour, which suggest that China can no longer rely on the 'easy' productivity gains associated with favourable demographics and from shifting labour from agriculture to the modern sector.

In the popular debate, China's transition to a new growth model is often focussed on the need to increase households' share of income and reduce the current account surplus. In truth, there are a number of challenges arising from China's extraordinary rise that need to be addressed, including regional economic and social disparities, rising income inequality, and growing stresses on the environment. A central theme, however, is that they are all to varying degrees related to the underlying institutional and economic structure of the economy that have driven China's export- and investment-led growth.

A more sustainable growth model, therefore largely centres on the need to address distortions, incentive structures and rent seeking behaviour that prevent more inclusive and sustainable growth. Factor market reforms will play a key role in addressing these economic challenges, facilitating China's transition to a more sustainable growth model. Since the late s, China's rapid growth has been closely associated with economic reforms that liberalised almost all product markets, providing price signals for consumption and production decisions.

However, price controls remain in place on virtually all factors — capital, land, labour, and energy — which distort incentives in the economy. While supporting SOEs, the tradable sector and investment, factor price distortions have contributed to excess capacity in some sectors, environmental degradation and income inequality. In its China report, the World Bank , p. The current structure of the financial system, characterised by the artificially low cost of capital, state intervention and the dominance of the banking sector in the allocation of capital, has served China well in the past, mobilising high national savings to fund rapid investment, and thereby growth World Bank, Indeed, 'financial repression' 2 , which can generally be described as the set of financial policies that channel to the state and its interests funds that would otherwise go elsewhere, has been a key element of China's development strategy over the past three decades Johansson, This has enabled China to allocate capital on favourable terms to preferred sectors of the economy.

However, there is wide recognition that carefully sequenced financial reforms are required if China is to place growth on a more sustain able footing. Rather than being determined by market forces, lending rates are bound by a floor of 30 per cent below the benchmark lending rate, while deposit rates are now capped at 20 per cent above the benchmark deposit rate. The lending rate floor and deposit rate ceiling, which is especially important given the limited alternative savings vehicles, have played a key role in promoting rapid growth through capital accumulation and supporting manufacturing capacity for exports, while securing banks' profitability with a guaranteed interest margin.

China's banks have benefited from guaranteed net interest margins for many years, peaking at 3. This has contributed to the nearly doubling of after-tax net profits of Chinese banks in the past five years. This strategy, aided by China's closed capital account, has worked well in many respects, including helping to ensure a stable funding environment and the stability of the banking system over the past decade.

However, the benefits of such a strategy are diminishing, with growing risks of capital misallocation and rising economic distortions manifested as asset bubbles, over-capacity in certain sectors and debt concerns at the local government level. Artificially low deposit rates are an implicit tax on household savings, while the low cost of capital encourages leveraging and inefficient investment, putting financial stability and growth at risk.

Moreover, while the banks have been able to generate significant profits, the guaranteed interest margin has not been conducive to the development of a more efficient and commercially-based banking system. In China, the banking sector dominates the financial landscape. While it has progressed significantly over the past three decades, the state retains control over the major banks and therefore, much of the financial sector.

Of the further 13 other large banks that are classified as joint stock holding banks, 11 are controlled by the state Johansson, The banking system remains a key policy instrument of the state and credit allocation is not always channelled on commercial grounds for example the response to the global financial crisis. On average, bank lending has accounted for approximately three quarters of credit extended in China over the past decade.

In addition, state controlled banks hold approximately 70 per cent of banking assets with the 'big four' alone accounting for over 40 per cent of banking assets. The state's control of the banks provides it with significant control over the economy, particularly one that has grown to rely heavily on investment.

However, the cost is that the financial sector does not effectively price risk, leading to problems of capital misallocation. The main beneficiaries of this system are SOEs, local governments, infrastructure developers and other institutional borrowers. The losers are the Chinese savers including households, whose savings effectively subsidise investment funded by the banks.

The banks offer returns that are typically low, and often below the rate of inflation, implying that there is a significant financial transfer from households to banks, SOEs and other institutional borrowers. The future of SOE reforms is central to China's transition towards a new model of growth that will rely critically on dynamic modern enterprises that are innovative, efficient, and competitive.

Much of the past reforms were aimed at making SOEs market oriented business entities through withdrawing them from competitive industries, encouraging the growth of the non-state sector, and pushing remaining SOEs to improve corporate governance. These reforms, if thoroughly carried out, could lay a solid microeconomic foundation for China's sustainable growth.

However, to date their success has been mixed, highlighting that SOE reforms are still very much a work-in-progress. On the surface, SOEs have made a turnaround in their financial performance since the late s, when at one stage the whole sector was close to loss making.

After a two-year fall following the onset of the global financial crisis, the average ROE in recovered to just below the pre-GFC level. However, SOEs' remarkable change of fortune has been significantly aided by preferential policies and regulations in their favour. The state has also created administrative monopolies that restrict entry and competition from non-state firms in a wide range of activities, such as services and industries that it regards as strategically important.

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As a result, SOEs continue to dominate in electricity, petroleum, aviation, banking and telecommunications industries. In addition, SOEs continue to receive explicit and implicit state subsidies, including low effective tax rates, low dividend payouts, and little or no royalties on resource extraction. Compared to non-state firms, SOEs are in a much better position to receive subsidies on key inputs such as energy, water, land, and cheap capital from China's state owned banks.

Protection, subsidies, and preferential treatment have artificially propped up SOE profitability, which, if calculated on the costs of doing businesses by non-state firms, could be much lower or possibly negative. According to an estimate made by Unirule , an independent Chinese think tank, the average real ROE of SOEs from to is negative if benefits from various preferential policies and fiscal subsidies were stripped from SOEs' profits, and the real cost of land, resource and capital were included as expenses. According to the World Bank , p. SOE profits have been largely retained for internal uses.

Until very recently, SOEs were not required to distribute any dividends. While this is changing, the payout rates remain low. Not surprisingly, SOEs tend to use their retained profits for investment and internal welfare, which in turn has contributed to inefficiency and resource misallocation.

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At the heart of the challenge for SOE reforms is the need to transform the relationship between the state and SOEs, to separate the state's role as a provider of public goods and services from the SOEs' role as commercial entities responsible for their own profits and losses. Of course, there is also scope to increase the role of the private sector in some sectors to promote competition and new investment. At the 18th National Party Congress this year, the Chinese Communist Party held the first phase of the transition to its 'fifth generation' of leaders, a transition that wi ll see a comprehensive turnover of the principal figures responsible for China's economic policies.

While the shape of economic policies under the new leadership remains uncertain, China's leadership has a growing sense of the economic imperative to undertake further structural reform. The leadership is fully aware that the Party's survival is dependent on continuing economic and social progress. Previous economic reform exercises in China have involved the state loosening controls on the economy to create space for the private sector to drive economic growth and employment.

For example, Deng's opening-up of the economy in and China's subsequent accession to the WTO in allowed the non-state sector to grow and exploit business opportunities, including in international trade. The SOE reforms of the s unlocked resources in the economy and opened up domestic markets to greater private sector participation. Under China's state capitalism model, the private sector has been allowed to grow within the parameters set by the state, while the state has maintained control over key strategic sectors of the economy.

China's financial system is dominated by the activities of the big, state-owned policy banks. Interest rates are regulated, credit is rationed and banks have been given direction on who they should lend to. SOEs dominate other core sectors, such as communications, energy and resources. These controls are consistent with China's political model, which retains a central planning ethos.

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The ability to direct capital and control strategic sectors of the economy are powerful economic levers, as well as sources of political power. The ability of a central decision-making process to efficiently guide capital in an increasingly large and complex economy is now being called into question, and most of China's pressing economic reforms involve further expansion of the role of the private sector.

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This is evident in a number of areas. In respect to the financial sector, there is a recognised need to better price risk and allow commercial considerations to guide the allocation of capital. Continuing state influence in the allocation of capital runs the risk of capital misallocation, mispricing of assets and bad debts. Similarly, as China seeks to promote new growth drivers, including in the services sector, it needs to allow non-state investment to compete equally with SOEs in these industries.

Demographic Transitions

Of course, letting go of these areas of control to make more room for the market raises a number of difficulties. A significant amount of wealth has been generated in China around the current model, creating strong vested interests. While there would be many winners from reform there would be a powerful group of losers. Moreover, ceding power to the market would lead to a watering down of Party influence. All countries seeking to take on structural reform face these sorts of issues. There are always groups that benefit from the status quo, and the benefits of reform are often diffuse.

But a feature of the Chinese system is that the leadership derives its power more directly from those who stand to lose from a process of further market-oriented reform. Following three decades of rapid growth, China has reached a period where the build-up of a number of economic, social, and environmental challenges need to be addressed. There is no doubting the potential for further impressive growth in the Chinese economy as China seeks to continue the process of catch up. But the older means of realising these benefits are in many respects approaching their 'use by date'.

The limits of the current growth model are already starting to bite on the Chinese economy, and will become more evident over the next decade. This presents a range of policy challenges for China's incoming leadership, whose ability to adapt to the new economic landscape will be tested by a range of economic and political obstacles to reform. China has a complex domestic reform agenda ahead if it is to shift to a more sustainable growth model and transition from a middle- to high-income country.

It will need to manage the contradiction between market and command elements of the economy, and overcome conflicting interests. Given the complexities that structural change entails, and the serious challenges they pose to both the current economic and political models, China's leaders will be particularly cautious during the new period of transition.