The Cost of Doing Business: Implications of Urban Bias in China's Economic Development

Source: The Telegraph. Picture taken of Chinese migrant worker's returning home for the Lunar New Year

China’s economic development has had important changes in policy that adversely affected the indigenous private sector and more fervently favored the system of larger, urban-based SOEs and FIEs. This change resulted in increased income inequality in China that was to persist through out the 1990s and continues today. The reform period known as the “Tiananmen Interlude” saw rural household income grow at the lowest rate since the beginning China’s economic reform, and nonagricultural business income in the rural areas actually declined by 5%.[1] The slowdown in business opportunities combined with vast regional disparities between the FDI of rural and urban provinces and led many rural Chinese to migrate to the eastern and coastal cities as laborers in the 1990s, contributing to the widening income and wealth inequality.[2] Changes in political leadership and policy were key in bringing about the changes in ideology that altered the policy climate. In the 1980s, China’s political leadership all had backgrounds in the more entrepreneurial rural areas as opposed to the highly urban experiences of the Jiang Zemin headed leadership. This marked a changing of the guard to a more technocratic and urban focused China along the lines of the Shanghai development strategy. Since strong central planning was a hallmark of the Shanghai political experience, having the most powerful leaders coming from that type of political background would have serious policy implications for the urbanly-biased direction of China’s development.

There are several definitions and classification schemes to determine the size of the Chinese private sector. This is due to several complex legal statuses that private companies operate under in China. One important distinction is that between indigenous firms and foreign invested enterprises or FIEs. The most universal classification of FIEs in China is firms with at least 25% foreign equity ownership.[1] This legal status allows FIEs to benefit from a myriad of favorable government policies toward that afford them both technological and institutional advantages over their indigenous counterparts. This is a theme that we will return to often, as we will continue to see that policy choices increasingly favored and benefitted FIEs, propped up SOEs, and continue to adversely affect the prospects of indigenous private firms.

Tracking fixed-asset investments of the different classes of firms operating in China can be used to measure the affect of Chinese government policies on the growth of different sectors of the economy while controlling for firm type. This is because the government heavily controls fixed-asset investments compared with other measures like output, which are subject to trends in the economy not as affected by government policy. Fixed Assets are also an important measure in the expanded DuPont System for calculating a firm’s profitability by Return on Equity.  Return on Equity is routinely used as a proxy for estimating firms’ growth prospects. Fixed Assets are a component of Asset Turnover, which is one of the 5 components of the DuPont System ROE.[1] Privately run firms would only purchase fixed assets when they can be reasonably confident of maintaining a sufficiently high ROE. Since the purchase of fixed assets is largely affected by the Chinese government’s policies, subsector analysis of changes in fixed-asset investments by different classes of Chinese enterprises enable us to gauge how the Chinese government’s policies explicitly deter or encourage them to grow.

 Examination of the data showed that indigenous private sector share of fixed-asset investments was at a peak of 21.4% through the 1980s followed by a sharp decline to 13.3% 1993-2001 accompanied by a real annual growth rate that fell more steeply from 19.9% to 2.6% in the Tiananmen Interlude period. Rural private sector’s share of fixed asset investments was 19.2% and real annual growth rate of the rural private sector was 19.1% in the 1980s, but were hit even harder declining to 9.5% in 1993-2001 and 1.1% in the Tiananmen Interlude period respectively. Fixed-Asset Investment for indigenous private businesses recovered to 14.7% 2002-2005 along with a real annual growth rate of 26.6%.  This same data shows SOEs’ real annual growth rate was 23.8% during the Tiananmen Interlude, 9.1% 1993-2001, and 13.4% all while commanding more than 80% of the Fixed Asset Investments over the entire period.[3

] This means that the indigenous private sector had to do more with less. The surge in growth in China’s private sector during the 1990s must be then result of continued support for FIEs. This is corroborated by foreign investment’s share of fixed asset investments climbing from 3.8% in 1982 to 11.8% in 1996.[4] This translated into FIEs accounting for a whopping 72% of fixed asset purchases by private firms that don’t fall under the indigenous classification, which include joint-ventures, share-holding firms, and unclassified firms. Figures on the industrial value added and output of FIEs show that they gained much of their output growth at the expense of collectives TVEs with FIEs going from 15.38% to 23.98% and collective TVEs from 25.03% to 12.10% of industrial value added from 1995 to 2000.[5]

Another important factor in the growing urban bias is constraining of indigenous private enterprises’ access to financial assistance from the Chinese banking system and simultaneous crackdown on informal financing initiatives through out rural China, which was the breeding ground for much of the indigenous entrepreneurial activity. During the 1980s, Chinese banks and Rural Credit Cooperatives (RCCs) were explicitly directed to lend to private indigenous enterprises through a cooperative arrangement in which RCCs would put 30% of their deposits into state controlled banks like the Agricultural Bank of China while both would compete on loan making activities.[1]  The RCCs and state banks were also complemented by Rural Cooperative Foundations (RCFs), which bared the most resemblance to “savings and loan” banks as they were formed through the pooling of privately owned assets. These institutions enabled rural entrepreneurs and private TVEs to securitize their fixed-asset investments to create further capital for entrepreneurial purposes. These experiments in informal financial networks were left alone and openly praised by High-ranking officials like Madame Chen Muhua, then President of the People’s Bank of China. After 1992, Chinese banks and RCCs were instructed to tailor their loan policies to favor agricultural production of rural, non-farm business as a matter of industrial policy as well as begin the absorption of RCFs into the state banking system.[2] Essentially, these policies incentivize the banking sector to favor agricultural production in rural areas while simultaneously destroying the financial experiments that gave rural, non-farm entrepreneurs access capital sources. This led to massive under investment in non-farming enterprises in rural areas thus hampering their ability to grow in the 1990s while simultaneously exploding the pace of urban based growth led by SOEs and FIEs.[3]

The Chinese government’s courting of FDI began in earnest with the establishment of the Special Economic Zones (SEZs) in 1979 in a few select cities, and expanded them through out the 1980s through the Article 22 Provisions.[4] The reforms were the Chinese implementation of the classic FDI-induced, export orientation strategy utilized by the High Performing Asian Economies of Korea, Taiwan, Singapore, and Japan. Policies like this are hallmarks of the developmental state, and gave fiscal incentives to Chinese enterprises to engage in ventures of various classifications with foreign companies to encourage export of Chinese made goods, acquire foreign capital, and obtain advanced technologies to increase industrial productivity and innovation.[5]  Studies on the relative impact of FDI across varying industries, provinces, and firm classes in China are able to segregate the effects of FDI inducing policies on urban-based industry and rural private enterprises. Several of these studies have shown that favoring of firm level FDI inflow has resulted in a boon for urban-based SOEs and FIEs, but at the cost of rural regions and indigenous businesses that are based there with a total of 11 provinces in the central and western regions of China being net losers due to the impact of FDI. The only consistent winners across all of the models were the heavily urban areas of Jiangsu and Shanghai, and heavily export oriented Guangdong.[6] SOEs engaging in some form of endogenous research and development were shown to have increased innovative capacity if FDI was occurring in their industry whether or not that specific firm was part of a foreign venture.[7] This is consistent with the mantra regarding the technology spillovers that occur due to FDI inflows.

However, indigenous private firms in an industry with large FIE participation do not receive these technological or innovative spillover effects though there are positive externalities across different FIEs.[8] Even then, the indigenous firms do not receive an equitable level of benefit because the relationship between the presence of FDI in close geographical proximity to a firm and spillover effects that firm experiences are stronger for FIEs. The overwhelming majority of FDI inflows go the urban areas, so firms in rural areas where the indigenous entrepreneurial growth was strongest receive little to virtually no benefit from the FDI inducing policies. By contrast, the magnitude and positive nature of spillovers to SOEs and FIEs is strongest when FDI takes place at firm and regional level simultaneously.  This can also be seen in subsectoral analysis of industries in China highly dominated by SOEs and FIEs like the electronics sector. All of the Chinese companies dominating this industry critical for technological innovation from 1993 to 2005 were SOEs located in the coastal urban areas and FIEs with funding from Hong Kong or overseas Chinese, or MNCs.[9] However, the relationship between FDI and SOEs’ ability to innovate is shown to be subject to the law of diminishing marginal returns. This coincides with the idea that most foreign multinationals perform the more advanced or critical innovations in the FDI source’s home country, not through the firms that they engage in FDI with in the host country.[10]

These observations all have serious implications for the political economy of China. The urban focus of the majority of FDI inducing, export oriented, and SOE favoring policies mean that Chinese citizens in the rural areas see disproportionally fewer benefits to the policies that have dominated in China since the 1990s.Where these types of policies weren’t in place and informal finance systems in China were at least tolerated, indigenous private enterprise had some fighting chance. But rural entrepreneurs saw their sources of financing dry up along with being unable to combat the distinct comparative advantage afforded to SOEs and FIEs starting in the Tiananmen Interlude period. This precipitated a drop in indigenous private fixed asset investments that has persisted since, resulting in the mass migration of rural Chinese to the cities as workers in lieu of the option of added value rural entrepreneurial endeavors. Technological spillover effects due to FDI are highly constrained by Geography as well as Industry, so any productivity gains due to technology transfer had more effect in the urban areas than the rural ones, further contributing to the persistently rising income inequality across China’s provinces. These developments have in many ways bifurcated China into different paces of economic change based largely upon lines of geography between the city and countryside. Such uneven development calls into question the sustainability of China’s economic growth. The SOEs and FIEs draw largely upon the continuation of policies that enable their heavy influence on the Chinese economy, which has its own caveats regarding the ability for China to innovate. All of this suggests that China needs to continue reform of its economic system through continued reform of the SOEs. Moving toward a combination of further privatization of SOEs and tailor more favorable banking policy to foster indigenous private industry.

[1] Ibid p. 144

[2] Ibid p. 153

[3] Industrial Dynamics in India and China p. 208

[4] Foreign Direct Investment in China: Policy, Trend and Impact p. 3

[5] East Asian Miracle Project, p. 3

[6] How Does FDI Affect China? Evidence from Industries and Provinces (Journal of Comparative Economics, May 2007) p. 794

[7] How Determines Innovation in SOEs: The Role of Foreign Direct Investment p. 6

[8] How Does FDI Affect China: Evidence from Industries and Providences p. 788

[9] Industrial Dynamics in India and China p. 51

[10] What Determines Innovation Activities in China’s SOEs? The Role of Foreign Direct Investment p. 12


[3] Capitalism with Chinese Characteristics p. 21

[4] Foreign Direct Investment in China: Policy Trend and Impact p. 31

[5] Ibid p. 33


[1] Capitalism with Chinese Characteristics p. 15