Why China's Growth Model Makes Sense

In How The City Moved To Mr Sun (2012) Michiel Hulshof and Daan Roggeveen give a fascinating account of the emergence of China’s super cities. Over the past ten years the share of city dwellers in China rose from 39 to 53% of the population. That is, 180 million Chinese abandoned the countryside to start a new life in the city. By 2035 almost 70% of China’s population will be urbanized, according to the United Nations, the largest migration in human history. Investors have not waited for the arrival of the masses, but have started building cities in advance. As a result, the world’s most populated nation is home to quite a few ghost towns: endless rows of vacant buildings in anticipation of new residents.

China’s export- and investment-based growth model has met a lot of criticism, and even outright derision, in the West. The comparison with India, a country with almost as many inhabitants, raises the question whether the criticism is justified. India has done exactly what western economists believe is needed for sustained economic growth, that is make an early transition from exports and investment to domestic consumption. But while growth in China over the past five years fell by a third (from 12 to 8%), growth in India was cut by half (from 10 to 5%). India’s economic slowdown is all the more remarkable as India’s per capita GDP, calculated on a purchasing power basis, is still 60% lower than China’s, and so are labor costs.

As Nobel laureate Paul Krugman’s new trade theory shows, international trade does not only arise because of comparative advantages but also because of economies of scale. Not all goods are like wheat or bananas, which mainly depend on climate conditions, but there are goods like cars and computers as well. For those goods labor costs matter, but economies of scale are important too. This explains why particular industries concentrate in certain locations, as they thus benefit from a deep labor market for specialized skills and an expansive market for suppliers of specialized inputs.

According to Mr Krugman, it is often merely an accident where an industry locates. Silicon Valley owes its existence in large part to two young men named Hewlett and Packard, who started a company out of their garage. New York is New York because of a river, which mainly serves tourist boats these days. But even though it is mostly chance that determines where a particular industry locates, it doesn’t mean that you can’t lend chance a helping hand. And that is exactly what the Chinese government is doing with its large-scale investments in infrastructure, and to a somewhat lesser extent with its investment in housing.

Yunnan, one of the poorest provinces of China that is mostly known for its cuisine, saw international trade explode in the first quarter of 2013, rising by almost 50% compared to the previous year, while exports throughout China rose by a modest 13%. The most significant gains in Yunnan's trade came in the mechanical and electronic sectors, neatly fitting the new trade theory. It is hard to imagine that mountainous Yunnan, which is not located on the Chinese coastline but is bordering Tibet, Laos and Vietnam instead, would have experienced the same growth without the central governments’ years of investing in Yunnan’s infrastructure.

That is not to say that China’s growth model has no drawbacks. It obviously has. The smog in China’s metropolis is smothering large swaths of the population, even though the air pollution in Delhi is often worse. Food scandals are undermining consumer confidence. Environmentalists are raising alarm bells about the central government’s plan to build a series of hydropower dams in the Nu, China’s last free flowing river. The project may force tens of thousands of ethnic minorities in Yunnan to relocate. These are serious issues that the Chinese leadership needs to address.

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That being said, within the framework of the new trade theory, China’s investment-led growth model makes more sense than western economists give it credit for.

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