Modeling the post-reform Chinese economy

Poticy reibrms over the pasl decade

~~fla~~o~ have been a serious problem.

retical analyses of the two-tier price system in

exchange mechanisms in

546

cling approach used, special purpose variants of the model directed to particular objectives can readily be develoPed (e.g., Peng and Martin, 1991).

A central issue is the extent to which prir:es affect the allocation of resources in China’s “pia& qned commodit;. ec~r~?~y.” Therefor?, the relative importance of plan and market in the domestic economy and in the foreign trade sector are discussed in Section 2. The nature of the foreign exchange system and its implications for the economy arc analyzed in Section 3. Then, in Section 4, a general equilibrium modei is developed and applied to the analysis of a number of policy changes. Section 5 contains a summary and conclusions.

A major thrust of the reforms In China’s economy since 1978 has been to decentralize economic decision making away from central planning and toward provincial governments and producing enterprises. This process has involved increased use of markets as a means of allocating resources, although planning by central and provincial authorities remains important (NaJghton, 1985; Wong, 1985), partjc- ularly in influencing the distrmution of income.

The extent to which decision making has been decentralized depends upon the sector of the economy. It appears, for instance, that decision making has been substantially decentralized in the agricultural sector (Sicular, 1988; Lardy, 1983). Progress has been viewed as having been somewhat less rapid in the industrial sector (Naughton, 1985; Wong, 1985; Chinese Economic System Reform Research Institute (CESRRII), 1987), although recent work suggests that secondary market prices

al sector decisions (Byrd, system has also been t elements of central

rices. Enterprises are generally able to et, rather than official, prices and con-

levels under a system of legal secondary markets such as veloped under the two-tier pricing system.

While the existence of a quota delivery amount, or a corres contract to deliver a fixed amount of revenue, has no impact on allocation, output or free- a revenue transfer. Such transfers are, in principle, perfectly nondis- torting taxes whose only effect on resource allocation in the short run results from their effects on the distribution of income and, hence, on demand. In practice, however, pursuit of these economic rents is likely to lead to significant rent-seeking costs. These inefficiencies are likely to reduce the level of output, as noted by Chow (1988), although output and the composition of output should still remain responsive to relative price signals at the margin.

Factor markets are much less well developed than markets for commodities in China. However, there have been substan-iial advances in the development of markets tr) facilitate transfers of factors from one use to another. In principle, the contract employment system in state enterprises provides flexibility for labor mobility between enterprises and activities (Blejer, Burton, Dunaway, and Szapary. 1991, p. 7). In the increasingly important rural industry sector, there is now a sizeable pool of casual workers, and job assignment is no longer the major means of obtaining employment (Meng, 1990 p. 30 1). The development of capital markets and of specialized banks has increased the ability of investment to flow in response to economic incentives. Even before these reforms, there appears to have been a surprising degree of factor mobility in response to economic incentives, even though this mobility frequently involved transactions more complex and costly than simple transfer of ownership (see Tidrick and Chen, 1987).

Prior to 1978, the Chinese econo decisions on exports made within the with an assessment of the level of purposes. All foreign e was channeled th

s), with minimal o rodu~i~g enterprises and

548 Will Martin

ank, 1988, p. 22). re identified by MO

ion of an agency system for exports; state responsibility for profits and Josses in ex-

ovation by ente rises in foreign trade.

subsequent poiicy changes have been directed towxd implementing these objectives.

The adoption of an agency system involves the Fl’Cs acting purzly as agents and ?ayizg producing enterprises a price based on the world price less costs converted into domestic currency, rather than an ad- ministratively detern8ned price. At a formal level, the introduction of

is system has proceeded much less rzpidly than on the import side. owever, large numbers of FICs have been introduced and compe-

tition between them, either directly in terms of thz price paid or in- directly through the supply of inputs and terms of payment can be expected to push the effective prices paid for exports toward the prices that would arise from an agency system.

There has also been a substantial move away from state responsibility for profits and losses in external trade. Export subsidies required to meet the losses incurred by FTCs on exports declined from an estimated

export vake in 1986 to under 7 percent in 1990 and crapped on January 1, 1991 (Cheng, 1991). Clearly, removal of export subsidies reduces the scope for

ween world and domestic

r-t of thz 1980s.

rt e

The general nature of the import reg’ relatively little change in recent years. are:

*

.

*

e

command plan imports of a small number of ey raw materials such as steel, chemical fertihzer, rubber, timber, tobacco, grain, polyester, and other synthetic fibers (World Bank, !988, central allocation of foreign exchange for imports on investment projects; allocations of foreign exchange for other priority i

materials, spare parts, and equipment; noncentrally funded imports or imports subject to import licensing.

ergone system

The World Bank estimated command an imports to be around 48 percent and noncentrally funded imports percent of total imports in 1986. From subsequent interviews by the author, it appears that central purchases of many commodities declined markedly after 1986, with a corresponding increase in local orders, although some recentralization appears to have occurred in response to “disorder” at the peak of liberalization.

Nonplan imports are divided into restricted and nonres Restricted goods, of which there were 45 in 1986 (Worl p. 136) included most of the co mand plan imports (e. ber, timber, synthetic fibers, tobacco), “luxury” cons such as motor vehicles, televisions and re lines for such ’ ‘luxury’ ’ consumer durables.

e extent

550

subjected to more careful scrutiny. Ah province or enterprise, as well as imp explicitly subject to import licensing, it appeared, that a restricted import with suitable finance, an6 %r substitutes were readily available, would eventually receive approva; (World Bank, 1988 p. 113). Under these conditions, imports are essentially being constrained by the general shortage of foreign exchange rather than the commodity-specific import licensing system.

The import tariff in the benchmark period included a minimum tariff schedule and an import surcharge, whose combined rate ranged from zere to 200 percent (World Bank, 1988 p. 146). The overall pattern of the tariff schedule appears to be broadly consistent with the structure of import licensing, with those goods essentially banned under the import licensing system (such as motor vehicles) facing very high tariffs (200 percent in the case of motor vehicles). The overall pattern of the tariff schedule may provide at least a general guide to the pattern of Industry protection desired by policy makers and implemented through the range of instmments available to them.

For noncommand imports, the FTCs usually act as agents for the purchasing enterprises. The enterprises are generally free to select an appropriate FTC (World Bank, 1988 p. 23), making it highly likely that the price signals resulting from exchange rate changes and import tariffs would be transmitted back to t;ae importing enterprise.

3. F E

Given the apparent price responsiveness of the main sectors of the Chinese economy, the foreign exchange system can be expected to have an important role in influencing trade and the overall performance of the economy. Here, key features of the Chinese foreign exchange system are examfned and likely implications for the traded goods sector are assessed.

79, the exchange I ate had a relatively limited role in c allocation of resources. With a heavy emphasis on

~~ann~~g in determining the level and pattern of exports, the exchange ince 1979, the foreign ed. blajor reforms in

zed system of foreign exchange control with ding of foreign exchange (Zhang, 1987) but

c 3.72 Yuan/U.S. in July The exe

exchange to transferre ferences its value each use

of foreign Some degree arbitrage between ters is and reportedly the extent divergences betwee

markets relatively There are number of indications that exchange rate

substantially overvalued late 1990 that it overvalued to degree. Qne indication is “shortage” of exchange. which necessitated a of strong on the

and holding foreign exchange !9F)7) Such shortage arises at the rate of imported goods artificially cheap, seiiing goods the export is not ficiently attractive generate the of exports to purchase

imports demanded. indication of overvaluation of exchange is

vided by substantially higher prevailing in secondary markets foreign exchange. March 1989, rate on Shanghai secondary for foreign was reported be 6.6 U.S. dollar, above the rate of Yuan/U.S. dollar Eastern Economic 2 March p. 103) subsequently rose around 7.0 dollar prior a decline late 1989

Daily, 3 1989). The of the exchange rate late 1990 early 1991 the two muc closer with the market rate to 5.8 U.S. dollar the official rate rose 5.32 (China Report, June 1991 p. 5) although the gap widened agai Because transactions in these secondary markets are a

igh rates in the secondary market

552

1

2

.

/

m--e

S

Supply, Demand, and Prices of Foreign Exchange.

sidered by Desai and Bhagwati (1979). The upward sloping curve depicts the supply of foreign exchange at any given nominal ex

change rate (for a fixed numeraire price of non-traded goods) assuming an export demand curve with an elasticity greater than unity in absolute

terms of the single sector general equilibrium model proposed elo and Robinson (1989). it can be thought of as rei resenting

ossibilities around a fixed production possibiiiiy

numeraire price of non-trade

consumers.

ge from SS to the kinked curve S’S. rate. e,,. the i~tr~u~ti~n of foreign supply of foreign exchange from qO

perceg! retentim rate. q* intersection, and the

-percent retention rate was

l3e state will *pay ente or’ K&al emings and 63 As Eong a.5 this swap rate is

market rate, this met

In a s%auc context, in~e~%i~Ie to export and,

text, it also introduces

real consequences.

first considered. Then, the model s%ructure was specified, i%s database assembled, and the model constructed. Finally, the model was used for policy simulation. Each of thzse modeling stages is reviewed in this section.

A general equilibrium modeling approach was chosen for this analysis because of an interest in the effects of policies on the structure of the economy and the pervasive implications of policies such as the

rate and trade distortions discussed above. Dervis, de lMe10, inson ( 198 1) have demonstrated the feasibility of using such

resence of foreign exchange constraints, and Kis, son ( 1986) have applied models of this type to post-

reform socialist economies. Two recent World Bank papers (19SSa, 1985b) provide consistent

t-output tables on an SNA basis and estimates of many of the ameters (e.g. income elasticities) needed to construct a

on, Parmenter, Sutton, and Vincent, da%abase was the aggregation of the

relatively labor intensive c ing sector with the much more capital the database was based

important of these rice data to reflect

Like most mode et al.,

assumption that there is sufficient competition for unit profits (at market prices) to be driven to zero. As discussed in Section 2, the crucial assumption is that economi< agents respond to marginal market prices for inputs and outputs, rather than official prices. Although it is rec- ognized that the income reJistribution induced by divergences between official and market prices may have an impact on demand behavior, this second-round effect seems likely to have a relatively minor impact on resource allocation and, hence, has not been incorporated in the model.

Although agents are assumed to respond in a manner consistent with neoclassical theory to the market prices that they experience, th market prices are affected by distortions such as over-valuation of officiel exchange rate, the foreign exchange retention system, a import tariffs and licensing, all of which can be incorporated in model.

To facilitate solution by Johansen’s method, the model was linear- ized in percentage changes. Following Armington (1969), domestic and imported products are treate

s thus require changes in

of model, this su substitution (CES) technology.

from those sold on the e using a constant elasticity of transformation (CET) functional form (Robinson, (1989).

The model is short run in character, with capital assumed to be fixed in each sector. It would be possible to build a longer-run version of the model in which the capital stocks in each industry were endogenous,

investment behavior i China seems likely to be difficult to model adequately. In the absence of a well-developed theory of investment for China, investment in each sector has been specified as simply changing in line with total real absorption. As is common in short-run models, investment does not add to the effective capital stock. The underlying time period is assumed to be sufficiently long for new equipment and machinery to be produced but not brought into production.

Given the complexities of the government revenue and expenditure system in China (FHejer and Szapary, 1989), an explicit set of fiscal accounts was not incorporated in the model. Implicitly, it is assumed that the authorities make whatever adjustments to fiscal policies are needed to keep real absorption at an exogenousiy determined ievei. A skeletal monetary sector is incorporated to allow determination of the aggregate price level as a numeraire. This allows the user to specify either complete control of the money supply or any given degree of “slippage” and consequent monetary expansion.

source of data for the model was the World Bank (1985a, 198 I, the latest available at t

ckd. This M-de has the advant onventions, rather than the material product nese input-output tables. A Chinese input-

for 198 I (State planning Commission and State Statistical 7), was used to split the combined “Textiles’ ’ sector in

into separate textiles and clothing sectors.

by Anderson’s (1989, p. 70) concE

adjusting the prices in the original input-output table using a set of relativities between official and secondary market prices-obtained primarily from studies by Lardy (1983), the World Bank ( 198% ), and the Research Institute of the State Price Bureau of China ( 1988). industrial sector price relativities were for 1988, when 2 well-devcI set of secondary markets was in operation, while the a~ricuhural price relativities were based on a relatively complete set of estimates for 1982, updated where later estimates were available. rates used in the model database were based on thos early 1988, 3.72 Yuan/U.S. dollar for the official role and 5.7 Yuan/ U.S. doiiar for the secondary market rate.

The actual price adjustment factors used to convert the model from official to secondary market prices are presented in Table 1. The price adjustment factors are large for raw material inputs such as oil, metals, and coal, where official prices are reported to be substantially below secondary market levels. They are also quite high for agricultural products reflecting substantial differences between quota and secondary market prices. By contrast, the adjustment factors were low in sectors such as textiles and clothing and in most services sectors, where official prices did not appear to be so widely out of il

or where underpricing had been alleviated by t

construction of t 11985a. p. 51). ross output value of t

caw32 two-tier p-icing is YacP

it vallue changes were assu

vided by Lluch, Powell. and Williams ( 1977). virtue of the me used in their construction (Dervis, de

on demand systems: homogeneity of degree zero in prices and income, symmetry. and adding up.

Equation sets (2), (3). and (4) specify proportional changes in fixed irivestment, investment in stocks, and government co~surn~t~o~ demands for each commodity as equal to the proportional changes in FOSS real absorption in the economy. This behavioral hyp was chosen as a neutral benchmark, given the considerable inty about hots these categories respond to relative prices.

Equation set (5) summarizes C

( i 969) model. The demand for ex rts relative to e

Be

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564 Will Martin

sistency with most models of this type, intermediate iilputs arc assumed to be used in fixed proportion to outputs, that is, according to a Leontief t&mology. Equation set (7) aggregates intermediate usage, household stocks, consumption, and government demand into a total absorption variable for each good. Value share weights are used to convert this linear identity into percentage change form. Because export and domestic products are differentiated, export demand is not a component of total absorption of i.

Equation set (8) specifies imperfect substitution between domestic and imported products consistent with the Armington (1969) model. Equation set (9) specifies imperfect transformation between domestically produced products supplied to domestic and export markets. This equation is a linearization in percentage changes of the CET function discussed in the context of CGE models by Robinson (1989).

Equation set (10) specifies the demand for primary factor inputs by industry i as a function of the output level in industry i and the relative prices of each of the primary factor inputs (land, labor, and capitaij. It is assumed that these inputs can bc aggregated into a composite primary factor bundle using a CES function, and the demand equations are obtained by imposing the first-order conditions for cost minimi- zation and linearizing in percentage changes.

The market clearing conditions for commodities are specified in equation block ( 1 I). In (1 la) domestic demand for good i from domestic sources (q,?) is equated -with domestic production of good i for the home market (x,?). Similarly, export demand for good i from China must equal Chinese production of good i for export (x,, j.

Equation set (12) deals with market clearing for primary factors. Equation (12a) embodies the assumption, standard in models of this type, that labor is able to move between different industries in response to changes in the demand for labor. Although this is undoubtedly a strong assumption given the constraints on the physical mobility of labor in China, the explosive growth of the lightly regulated rural industries in China has greatly increased the opportunities for labor to move between agriculture and industry and between industrial sectors.

The stock of capital in each industry and the stock of land in each agricultural industry are specified exogenously in (12b) and (12~). Equaticn set ( 13) imposes the condition of zero pure profits on activities conduc ed at marginal (free-market) prices. In production, this condition &volves the inherent assumption of constant returns to scale- reasonable given the very large number of enterprises involved in most industrial (and certainiy agricultural) activities in China. Whereas the two-tier pricing system generates large profits and iosscs, these are

Modeling the Post-Reform Chinese Economy 565

assumed TV be inframarginal and, hence. irrelevant for short-run resource allocation.

The zero-profit or arbitrage conditions in exporting and importing are of vital importance and, therefore, are examined in some detail. The condition for the import market is simply a linear in percentage char ?e version of

P,, = P,“’ (I + T,) Q2

where Pi2 is the landed, domestic currency price of imported good i, Pim is the “world” price for imports of good i, Ti is the rate of tariff applying to imports of i (plus the tariff equivalent of any import quota), and @? is the secondary-market exchange rate. At the margin, it is assumed that the opportunity cost of a!1 imports involves the secondary- market rate. If an enterprise has less foreign exchange than it demands, it must purchase additional foreign exchange in the secondary market. If it initially has more foreign exchange than it requires, its opportunity cost of using foreign exchange is also the secondary-market rate.

In exporting, the nominal returns per unit exported depend upon the foreign currency price received, the rate of any export tax, and a weighted average of the official and secondary-market exchange rates. The higher the rate of retention allowed to enterprises, the larger the weight on the secondary market and, hence, the higher the domestic currency price of exports. Equation ( 13~) was derived by expanding ihe nonlinear export value equation about base period values for the retention rate and the official and secondary-market exchange rates. It allows the effects of changes in both the official exchange rate and in the retention rate applied in each industry to be examined. The weight PES reflects the base retention rate of 0.25 and allows the effects of recent changes from this level to be investigated.

Equation set (14) includes identifies to form aggregate GDP and absorption in current and constant prices. Equation (14~) is used to make aggregate real absorption an exogenous variable in the model. Equation (148) requires that total household consumption and the spending associated with investment and government purchases add to total absorption.

Equation set (15) defines the balance of trade, and equation set ( 16) includes identities for trade volumes and values. Equation ( 17a) is a demand for money equation, with a unitary income elasticity of demand imposed, which is used to determine tl:: model’s numeraire price- the composite price of absorption.

The final four equations of the model, ( 17b)-( 17e), define the price of each of the composite goods (import plus domestic sources goods)

566 Will Martin

consumed domestically and the price of composite goods (export pIus domestic destination goods) produced domestically and composite prices for total absorption and total GDP.

The complete model contains 1166 equations, and 1146 endogenous variables. The model is linear in percentage changes and was solved using the GEMPACK program (Codsi and Pearson, 1988).

In addition to the input-output data discussed above, the model requires that a number of elasticity parameters be specified. The elasticities involved were

* consumer demand elasticities; * elasticities of substitution between domestic and imported good

i (base value 2.0); * elasticities of transformation between domestic and export good

i (base value 5.0); 0 elasticities of substitution between Chinese exports of i and the

exports of other countries (base value 10.0); * the elasticity of demand for total world exports of i (base value

- 2.0); 0 the elasticity of supply of import i to China (base value 100); 0 the elasticity of substitution between primary factors in industry

i (base value 0.5)

As previously discussed, the consumer demand elasticities were derived using expenditure elasticities, budget shares, and the Frisch parameter. it seemed unlikely that reasonable estimates of the elasticities of substitution and transformation for each commodity could be estimated satisfactorily using the available data for China. Time series of the relevant market price data are extremely scarce, and, in any event, the time period over which enterprise managers have been free to allocate their resources in response to relative price changes is short. Accordingly, the approach taken was to impose selected base values chosen on the basis of the evidence from other countries, leaving open the option of examining the sensitivity of the results obtained to these assumptions.

The base value of 2.0 used for the elasticity of substitution between domestic and imported commodities is within the range of values used for this parameter in CGE studies. Although the values used in the Grais, de Melo, and Urata (1986) study range only from 0.4 to 1.2,

the corresponding parameters arc larger in many other CGE studies. If one accepts the weight of empirical evidence marshalled by Go’idstein and Khan ( 1085, p- 1076) that the aggregate e!asticity of import demand is in the range -0.5 to - 1 .O and believes that own price


elasticities for individual commodities are likely to be higher than the aggregate elasticity, then an elasticity of substitution of 2.0 at the individual commodity level would seem entirely reasonable.

Unfortunately, the empirical evidence on the elasticity of transformation between domestic and export production is extremely limited. The estimate of 2.90 cited by Tarr (1989, pp. 5-6) provides some indication of the order of magnitude, at least for manufactured products. Although it is well below the value of infinity implicit in models constructed without explicit transformation in production, it is well above the values of 0.5 and 1.5 assumed by Grais, de Melo, and Urata (1986). The evidence that the aggregate supply elasticity of exports may lie in the range from 1.0 to 4.0 (Goldsrein and Khan, 1985 p. 1087) also seems to point to higher values for this parameter than those chosen by Grais, de Melo, and Urata (1986, p 74). The value of 5.0 for individual commodities used in this study was subjectively set somewhat above the empirically estimated aggregate values given the well-known downward bias in these estimates resulting from the pervasive problem of measurement errors.

The elasticities of substitution between exports from China and other export products were set at 10.0 in the belief that Chinese exports of many products are close substitutes for other products in world markets. This assumption is higher than the few available direct estimates of the elasticity of export demand for China’s exports but the likelihood that such estimates are biased downward is well known (see, for ex- ample, Learner and Stern, 1970, pp. 56-74). For commodity exports, at least, the value of 10.0 does not seem unreasonable, and it is broadly consistent with values used in many other CGE modeling exercises (e.g., Dixon et al., 1982).

The base value elasticity of demand for total world exports was set at - 2.0 in light of the relatively low elasticity of substitution between domestic and imported goods assumed in the model. Because the focus of the model is on a relatively short lime period, supply adjustment in other countries may be fairly low, pla,ing the major burden of adjustment on world demand. Given China’s small share of world exports, the elasticity of demand for her exports would generally be expected to depend more heavily on the elasticity of substitution than the overall market elasticity of demand.

The very high base value for the elasticity of sup;;!y cf imports to China was chosen to make China essentiaily a price taker in the market for imports. Given China’s small share in most markets, this does not appear unreasonable as a working assumption.

The elasticity of substitution between primary factors was set to a

568 b’ill .Manin

base value of 0.5. This value was selected by Dixon et al. I 1982) after an extensive literature search. Although it is substantially below some of the estimates presented in the developing country literature (e.g., Limskul, 1988), it does not seem unreasonable as a short-run estimate, particularly when the effects of any constraints on adjustment resulting from the operation of the planning system are considered.

4.E Simulation Results

A number of simulations involving changes in major macroeconomic and trade policy variables were used to highlight major features of the model and of the Chinese economy. Results of the following experiments are reported in this section: a lo-percent devaluation of the official exchange rate; a lo-percent increase in the money supply; a l-percent increase in real ahsorption; an increase of 10 percent in the power of the tariff ( 1 + T,) in macl :rery , a major import competing industry: and an increase of 100 per\ nt (i.e., from 25 percent to 50 percent) in the retention rate for forcig,r exchange on apparel exports, a major and strongly export oriented sector. Simulation results are presented in ? able 3.

DEVALUATION OF THE OFFICIAL EXCHAMX RATE. In this experiment, a IO-percent devaluation of the official exchange rate was mod- eled with the money supply held constant as an initial assumption. As would be expected given the analysis presented in Section 3, official exchange rate devaluation resulted in an appreciation in the secondary- market exchange rate. The lo-percent depreciation of the official exchange rate is estimated to cause a 6.2~percent appreciation of the secondary-market exchange rate, narrowing the gap between the official and secondary market in the model database from 53 percent to 3 1 percent. The improvement in efficiency resulting from the expansion of the repressed export sector leads to an increase of 0.3 percent in real GDP, measured as nominal GDP deflated by the price of consumption goods.

The devaluation results in sizable expansions of both export and import volumes and in an improvement in the balance of trade measured in domestic currency. The real wage deflated by the price index for domestic absorption rises by 0.3 percent as labor is drawn from the relatively capital intensive import competing sectors into the relatively labor intensive export sectors such as textiles and apparel.

The effects of devaluation on the pat& of sectoral outputs are much less marked than t c effcts on tr levels in the aggregate.

Modeling the Post-Reform Chinebe Economy 562

Table 3: Effects of Changes in V~jor Macroeconomic and Trade Policies’

Rsetention Officia! Power of rate for

exchange Money tariff on apparel rate SUPPlY Absorption machinery exports

(10%) (10%) (1%) (10%) wO%)

Mrum Variables

Secondary market

exchange rate

-6.2 16.2 -6.6 - 1.4 - I.1

Real GDP

Export volume

Import volume Consumption real vqcz

Balance of trade

(c/F of GDP)

0.3 -0.3 0.3 -0. I 0.0 Il.6 - Il.6 - 2.6 - I.2 1.8 10.7 - 10.7 9.5 - 1.1 I.8 0.3 - 0.3 1.6 -0.1 0.2 0.8 -09 -0.6 0.0 0.1

Absorption deflator 0 10.0 - I.0 0 0

Sectural Oulpurs

Crops

Animal husbandry

Metallurgy

Electricity

Coal

Oil

Petrol refining

Chemicals

Machinery

Building materials

Wood

Food

Textiles

Apparel

Paper

Miw. manufactures.

Construction

Freight transport

Passenger transport

Commerce

Miscellaneous set-we5

Education and health

Public administration

Housing

-0.2 0.2 - 0.2 -- 0.1 -0.1 0.3 -0.3 0.6 0.0 0.0

-0.1 0.1 - 0.4 0.0 -0.1 0.0 t-f.0 0.0 0.0 0.0 0.2 -0.2 -0. I 0.0 -0. I 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

-0.1 0.1 0.2 0.0 0.0 -0.2 0.2 --0.2 0.8 -0.1

0. f 0. f 0.6 0.0 0.0

-0.4 0.4 -0.9 -0.2 -0.2

0.3 -0.3 0.5 0.0 0.0

0.6 -0.6 0.0 0.0 0.6

I.1 - 1.2 0.5 0.0 3.4

0.0 0.0 0.0 0.0 -0.1

0.9 --O,‘j -- 0.6 -0.2 “2.2

0.0 ::.o 0.8 0.0 0.0

0.5 -0.5 - 0.6 -0.1 -0.1

0.0 0.0 -c.3 0.0 0.1

0.6 - 0.6 -0.0 -0.1 -0.1

0.0 0.0 0.6 0.G 0.0

0.0 0.0 I.0 0.0 0.0

0.0 0.0 I .o 0.0 0.G

0 0 0.0 0.2 0.0 0.0

-AlI responres are in percentage changes.

570 Will Martin

because much of the increase in trade results from an increase in intraindustry trade rather than intersectoral movements in the allocation of resources. However, there is a noticeable tendency for export- oriented sectors such as apparel, textiles, and miscellaneous manufacturing to expand while strongly import competing sectors such as machinery, chemicals, and crops contract. Some sectors, such as freight transport and the commerce sector that are not directly traded, but linked to the traded goods sectors through input-output linkages, also expand noticeably. Interestingly, the devaluation has virtually no effect on the output of the non-traded goods sectors such as miscellaneous services, public administration, and education and health.

MONEY SUPPLY. The money supply experiment is of interest bot in its own right and as a complerr~nt to the devaluation experiment. Whereas the devaluation experiment assumes that the authorities can effectively control the money supply, a devaluation may well be associated with an increase in the money supply and, hence, with rising prices (see Blejer, et al. 1991 ior a discussion of the close linkage between money supply changes and inflation in China). In this situ- ation, it is necessary to consider the combined effects of devaluation and changes in the money supply. Because the model is linear in percentage changes, the effects of any combination of shocks such as these two can be obtained simply by adding up the effects of the individual shocks.

In the absence of nominal price rigidities, a change in the money supply would have no real implications because the behavioral equations of the model are homogeneous of degree zero in prices. An increase in the money supply would raise all nominal prices propor- tionally but change no real variables. Given China’s foreign exchange system, however, an increase in the money supply leads to changes in relative prices as well as to an increase in the general price level.

Model results for a lo-percent increase in the money supply are presented in the second column of Table 3. For all real variables, the results are the same as for a lo-percent uppreciation of the official exchange rate and, hence, opposite in sign to the devaluation considered above. Thus, real GDP declines, trade volumes contract, and real wages fall. Activity declines in the export-oriented sectors and expands slightly in the import-competing sectors. The notable difference between the two experiments is the rise of 10 percent in nominal prices resulting from the increase in the money supply. The 16.2-percent appreciation of the secondary-market exchange rate in this case has the same effect on relative prices as a 6.2-percent appreciation with the numerairc price held constant.


Combining the two shocks provides an indication of the effects of a devaluation when the money supply is imperfectly controlled. From the results, it is clear that continuing increases in the money supply and the price level would tend to offset the beneficial effects of de-. valuation. A devaluation together with an equal increase in the money supply would have no real effects and would merely result in an increase in the price level.

ABSORPTION SHOCK. Results for an increase of 1 percent in aggregate real absorption are presented in column 3 of Table 3. Because of the way the model is structured, these results incorporate two distinct effects: the positive effect of increased demand for non-traded goods on their relative price and the negative effect of increased real demand on the general price level given a fixed nominal money supply.

An important effect of the l-percent demand shock considered in Table 3 is to cause an appreciation of the secondary-market exchange rate. This appreciation is due primarily to the need for a;n increase in the price of non-traded goods relative to traded goods following an aggregate demand increase (Salter, 1959). Because the overall price of absorption is constrained in this experiment, the requi:ed increase in the relative price of non-traded goods can only be brought about throug;. an actual fall in the price of imported goods. A secondary cause of the exchange rate depreciation is the decline in the price level resulting from an increase in real spending with a fixed money supply .

constraint. As can be seen by comparing the results with the second column of Table 3, the l-percent decline in the general price level associated with this shock causes only 1.6 percent oi tht: ioial 6.6- percent appreciation (decline) in the secondary-market exchange rate.

The association of an increase in demand with a decline in the price level may at first seem unrealistic given the tendency for inflation to be associated with periods of excess demand. However, there does seem to be strong evidence that the price level in the post-reform Chinese economy is influenced primarily by changes in the money supply (Blejer et al., 199 1) and increases in demand can, through appropriate financing, be prevented from influencing the money sup- . ply. The model allows the real implications of increases in demand to be examined separately from any monetary implications of the shock. If desired, the combined effects of an aggregate demand shock and any given level of monetary expansion can be analyzed simply by combining the effects of ;hese two shocks.

Real GDP increases by 0.3 percent following the absorption shock, primarily because the adverse effects of the foreign exchange dis- tortion on import levels are reduced and the preexisting bias against

572 Will Martin

imports is mitigated. Import volumes incrcasc by 9.5 percent ir. response to increased demand and the lower domestic price of imports. Exports decline because the price of exports falls relative to the price of non-traded goods. The consumption real wage rises substantially necause output prices increase most strongly in the non- traded goods sectors, many of which are very labor intensive both in their direct and indirect labor requirements (Peng and Martin, 1991). The balance of trade deteriorates by 0.6 percent, as demand increases relative to income.

Sectoral output effects of the absorption shock depend upon the price and income elasticities of demand and the trade exposure of the sector. Relatively large output expansions occur in non-traded goods industries such as public administration and construction for which demand is not price responsive in the model. Output effects in the traded goods industries tend to be small or negative, with declines in output in some import competing industries such as crops and metallurgy, and in particularly labor intensive industries such as miscellaneous manufacturing. Some traded goods industries such as processed food, animal husbandry, and apparel, for which income elasticities of consumer demand are relatively high, experience increases in output.

TARIFF ON MACHINERY. This sector was chosen for analysis because machinery imports into China are large and because tariff rates and other protective barriers in this sector appear to be relatively high. The experiment reportca is for a change of 10 percent in the power of the tariff (1 + Ti) in this industry.

This simulation highlights the effects of direct trade restrictions on the secondary-market exchar:ge rate. An increase of 10 percent in the tariff on this sector alone reduces the secondary-market exchange rate by 1.4 percent. Real GDP declines by 0.1 percent as resources are distorted away from their most efficieqt use. imports decline by 1.1 percent but exports declir to a grtdter degree, by 1.2 percent. Real wages decline slightly as resources are drawn into this relatively capital intensive sector and out of more labor intensive industries.

The output of the machinery sector increases by 0.8 percent as impor% of machinery are restricted and &mestic producer prices rise. The effects on the output of other industries are relatively slight. In- terestingly, however, these impacts do not fall only on export industries. The decline in the secondary-market exchange rate makes nonmachinery imports cheaper and results in small output declines in some import competing sectors such as crops and wood.


FOREIGN EXCHANGE RETENTION RATES FOR APPAREL. The final experiment presented in Table 3 is an increase of 100 percent in the foreign exchange retention rate for apparel exports-an increase from a base level of 25 percent up to 50 percent.

This increase in retention rates expands exports in this major export category, iircreasing the supply of foreign exchange and lowering its price. The increase in this sector alone causes the secondary-market exchange rate to appreciate by just over 1 percent. Export volume increases by almost 2 percent, allowing a similar increase in the volume of imports. The consumption real wage rises by 0.2 percent because of the expansion of this labor-intensive industry. There is no observable change in real GDP. Efficiency gains from expansion of this labor- intensive industry are offset by the introduction of Distortions between this and other industries. The volume of output rises by 3.4 percent in apparel and 0.6 percent in text&s. Slight reductions in output occur in a range of other industries as resources are drawn into apparel. The decline in the price of imports brought about by appreciation of the secondary-market exchange rate contributes to output declines in import competing industries such as crops, metallurgy, and wood. Some labor-intensive industries such as paper and miscellaneous manufacturing also face small output declines as real wages are driven up.

5. CONCLUSIONS

The analysis presented in the paper draws on the theoretical literature and the available empirical estimates to develop a price-responsive model of the post-reform Chinese economy. The model takes into account the two-tier pricing system in domestic markets and the two- tier system for foreign exchange. For this paper, the modei was used to examine the consequences of a range of macroeconomic and trade policy instruments, both to examine the properties of the model and to provide insights into the effects of these policies on the Chinese economy.

The results obtained from the model were consistent with theory and plausible in magnitude and provide some useful policy insights as well as numerical estimates not available without a formal model. One simulation highlighted the effectiveness of exchange rate devaluation in siimuiaiing trade expansion, raising efficiency, and strengthening the demand for labor. Another experiment illustrated the trade restrict- ing effects of a money supply expansion, and its ability to offset, partially or completely, the beneficial effects of devaluaEion. An increase in total domestic absorption, with the money supply effectitve!y

<-+ _” _ Will Martin

~~~tro~~e~. u’as found to result in appreciation of the secondary-market y combinations of these measures can

by simple addition, allowing the effects of alternative to be evaluated and changes in the economy to be

e ~~te~~t~o~ between trade policy measures and the secondary- et exchange rate was illustrated by examining changes in trade

les for two major industries. An increase in the level of e machinery industry lowered the demand for foreign

hence, the secondary-market exchange rate. An increase n rate applied to exports of apparel increased the supply

ge and lowered its secondary-market price. ussed in this paper is extremely flexible and can be

used to ana!yze the consequences of a wide range of pohq changes and external shocks both for the economy as a whole and for a wide

uction sectors. Its ability to incorporate the linkages ct and factor markets is of particular importance given

n China with the consequences of policy changes for nt. .Model simulations of the type presented in this paper

understand many of the features of the post-reform Chinese economy and assist in the formulation of policies for economic m~gement and development.

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7

Modeling the post-reform Chinese economy

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Transcript of Modeling the post-reform Chinese economy