Will China Escape the Middle-income Trap?

Will China Escape the Middle-income Trap? A Politico-economic Theory of Growth and State Capitalism Yikai Wang University of Zurich February 5, 2014

China s Growth Rapid growth in China in the last 3 decades Without democracy Question: is the rapid growth sustainable? Optimistic: success with state control over the economy (Musacchio 2012) Pessimistic: state distortions and extraction (Acemoglu and Robinson 2012)

China s Political Transition If Acemoglu and Robinson are right the growth will soon slow down Question: will it trigger political changes? Democratization: citizens do not support the current regime Persistent inefficient institutions: political support from the beneficiary

This Paper: Research Questions A theory of politico-economic transition 1. Answer the above questions Will China s growth continue? Will democratization occur? 2. Understand China s recent development Low wage that contributes to rapid growth Middle-class support of the existing regime and more...

Large State-Private Wage Gap State workers get 30% higher wages, ceteris paribus 0.5 State Sector Wage Premium 0.45 0.4 0.35 Log Wage Differential 0.3 0.25 0.2 0.15 0.1 0.05 0 1992 1994 1996 1998 2000 2002 2004 2006 Year Source: Ge and Yang 2012.

Political Support Support for Democracy coefficient Employment in State Sector -1.23** Middle-class Membership -0.54** Party Membership -0.37 Source: Chen and Lu 2011. State workers are less supportive for democracy So do the middle-class, including private entrepreneurs Support for multiparty competition: 24.9% v.s. 38.7% (middle- v.s. lower-class)

Partial Privatization State employment share declined rapidly but now stays at 20% (40% in the manufacturing sector) 1 Employment Share of the State Sector in the Urban Area 0.9 0.8 0.7 Manufacturing 0.6 0.5 0.4 0.3 All 0.2 0.1 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Year Source: China Statistical Yearbook

Increasing Capital Market Friction Large and increasing capital market wedge between state and private sectors Capital Wedges between the State and Private Sectors 6.5 Difference of Costs for Capital 6 5.5 5 4.5 4 1990 1992 1994 1996 1998 2000 2002 2004 2006 Year

Preview of the Theory A political elite Controls state firms and extracts profits from them Controls the government and taxes private firms Political constraint Political support from sufficiently many citizens Policy tools State sector wages Bank loans to state firms Bank loans to private firms

Preview of the Theory Dual labor market High wages of state workers: turn them into supporters Low wages of private workers Capital market policies Encourages private sector growth when it is small Protect state employment when the private sector is large Over-investment in the state sector Restricted loans to private firms

Preview of the Theory A three-stage politico-economic transition Rapid Growth State Capitalism S u s t a ine d G row t h Middle Income Trap

Preview of Results A two-sector dynamic general equilibrium model Calibrated to China s economy! "# $% &'"($! )$ ' *+&& '$,' - $% -"../ 0)/!! 1'$"/ &'"($"2$" # 3#)'!"# )&"$/ -'4 $,'")$" # Rapid Growth State Capitalism S u s ta i ne d G r o wth Middle Incom e Trap 5. - )'$"2$" # 5!+!$"#. ' $%

Literature: Growth China s growth Brandt and Zhu 2000, 2010 Li, Liu and Wang 2013 Song, Storesletten and Zilibotti 2011 Middle-income trap Eichengreen, Park and Shin 2011 Fatas and Mihov 2009

Literature: Political Economy Institutions and Development Acemoglu, Johnson and Robinson 2001 Acemoglu and Robinson 2012 Inefficient political systems Acemoglu 2008 Acemoglu, Robinson and Verdier 2004 Robinson and Verdier 2013 Brollo, Nannicini, Perotti and Tabellini 2013

Model Environment: Agents Two sectors, state sector (S) and private sector (P) Three groups of agents Workers (w): supply labor to both sectors, size N w = 1 Elites (e): provide capital to sector S, size N e = 0 Private entrepreneurs (p): provide capital to sector P, size N p = 0 Two types of firms State firms (S): compete for capital and labor in sector S Private firms (P): compete for capital and labor in sector P S firms are less efficient Z S Z < 1 P

Environment: Political Systems Two political systems: democracy (D) and oligarchy (O) Democracy Median voter - the representative worker - controls the government Tax capital owners: elites and entrepreneurs Competitive equilibrium

Environment: Oligarchy Elites control the government to maximize their lifetime income Extract state profits Tax private sector Political constraint: enough supporters Policy tools

Breakdown of the Dynamic Equilibrium Infinite periods Within each period 1. Capital allocation in S and P sectors 2. Equilibrium given capitals Choices of Agents Political and economic outcome 3. Consumption and saving to next period

Democracy Wage and Labor in Democracy S Sector P Sector Marginal Return of Labor D y w D w D L S Labor in S Sector

Oligarchy: Key Assumptions Key assumptions Use high state sector wages to buy political support State firms decide employments to maximize profits Why not alternative non-distortive settings? Lump-sum transfer Commitment problem: Acemoglu 2003, Robinson and Torvik 2004 High cost: Reinikka and Svensson 2004 Employment subsidy and direct employment control Soft-budget constraint: Maskin and Xu 2008

Oligarchy: Labor and Wage Wages and Labor in Oligarchy S Sector P Sector Marginal Return of Labor w S = y D w D w w P L L D L S Labor in S Sector

Oligarchy: Political Constraints To sustain oligarchy, elites face two political constraints High state-wage constraint w S y D w Minimal support constraint L S L

Tradeoff 1: State Wage and State Employment Benefit: high wage buys political support of state workers Cost: reduces supporter base- state employment

Relative Size of State Capital Matters Private sector capital grows large, relatively small state sector capital Labor and Wages in Oligarchy S Sector P Sector Marginal Return of Labor w S = y D w D w L L Labor in S Sector

Large Enough State Capital Sustaining oligarchy requires large enough state capital K S relative to the private Enough state capital: [ L, L ] /0, oligarchy can be sustained Not enough state capital, [ L, L ] = /0, high enough wage leads to not enough supporters Economic power determines political outcome

Implications I State wage premium v.s. repressed private sector wage w S > w D > w P High capital labor ratio in the state sector (Song, Storesletten and Zilibotti 2012) Low capital return in the state sector

Low Capital Return in State Sector 0.8 Return to Capital 0.7 0.6 Private 0.5 0.4 0.3 0.2 0.1 State 0 1992 1994 1996 1998 2000 2002 2004 2006 Year Source: Brandt and Zhu 2010

Implications II The middle-class benefit from the distortive policies 1. Elites: tax extraction 2. Entrepreneurs: cheap and abundant labor in the private sector 3. State workers: high state wage 4. Private workers: suffer from low wage Political support from the middle-class: state workers and entrepreneurs (Potentially) fast capital accumulation and growth - in the dynamic model

Breakdown of the Dynamic Equilibrium Infinite periods Within each period 1. Capital allocation in S and P sectors 2. Equilibrium given capitals Choices of Agents Political and economic outcome 3. Consumption and saving to next period

Model Setting S and P Sector Capital State sector capital K S Set by the government (by controlling the bank loans to state firms) Borrow at interest rate R from the international market Private sector capital K P Financed by entrepreneur assets and bank loans Credit constraint: K P ηa p Leverage of private firms η Set by the government η [ η, η ] Encourage or repress the private sector

Model Setting Infinitely-lived Agents Elites and entrepreneurs live for infinite periods with discount β Hand-to-mouth workers: consume the current period income and care only about current period income Log-utility, an entrepreneur saves the constant fraction of her lifetime income: β

The Representative Elite s Problem First she decides to stay in oligarchy or to democratize, { } W (a e,a p )=max W O (a e,a p ),W D (a e,a p ). In oligarchy, she decides government policies, consumption and saving W O (a e,a p )= max logc e + βw ( a e ),a p η,k S,w S,τ p,c e,a e s.t. w S y D w (η,k S,a p ), L S L, a e = Ra e + y e (η,k S,w S,τ p,a p ) c e, a p = βy p (η,k S,w S,τ p,a p ).

The Representative Elite s Problem The return to a e is always R. Its only role is to smooth consumption. So the problem in oligarchy can be separated into two parts Government policies to maximize the lifetime income V O (a p )= max ŷ e (η,k S,w S,τ p,a p )+ 1 η,k S,w S,τ p R V ( a p ) s.t. w S y D w (η,k S,a p ), L S L, a p = βy p(η,k S,w S,τ p,a p ). Consumption smooth using a e. Similarly, { } V (a p )=max V O (a p ),V D (a p ).

Steps to Explain the Results Choices of K P (η),k S,w S,τ P in 3 steps 1. w S,τ p K P,K S 2. K S K P 3. K P (η) a p

w S,τ p K P,K S w S = y D w (η,k S,a p ) L S = L, least distortion τ p = τ

K S K P Variables Depending on State Sector Capital, Given Private Capital State Sector Labor Dummy for Oligarchy 1 0.25 0.2 0.15 0.1 0.05 0.8 0.6 0.4 0.2 0.5 1 1.5 0 0.5 1 1.5 0.2 Elite Current Period Income 0.05 Marginal Return of S Capital to Elites 0.15 0.1 0 0.05 0 0.5 1 1.5 0.05 State Sector Capital 0.5 1 1.5

K S K P Variables Depending on Private Sector Capital State Sector Capital State Sector Labor 0.55 2 1.5 1 0.5 1 1.5 2 2.5 3 0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.5 1 1.5 2 2.5 3 Elite Income from State and Private Sectors 0.35 0.3 Private 0.25 0.2 0.15 State 0.1 0.21 0.2 0.19 0.18 0.17 Elite Income 0.05 0.5 1 1.5 2 2.5 3 0.16 Private Sector Capital 0.5 1 1.5 2 2.5 3

Tradeoff 2: Private Sector Capital Benefit: tax income Cost: state sector investment to maintain enough state workers Elites prefer a median level of private capital

K P (η) a p 2 Variables Depending on Entrepreneur Asset Private Firm Leverage State and Private Capital 2.5 1.8 1.6 1.4 1.2 2 1.5 1 0.5 Private State 1 0.5 1 1.5 2 2.5 0.5 1 1.5 2 2.5 0.55 0.5 0.45 0.4 0.35 0.3 0.25 0.2 State Sector Labor 4.32 4.3 4.28 4.26 4.24 4.22 4.2 4.18 0.5 1 1.5 2 2.5 Entrepreneur Asset Elite Lifetime Income 0.5 1 1.5 2 2.5

Dynamics: Three Stage Transition Given the solution above Simulate the dynamics starting from a small a p Red line: oligarchy Blue line: democracy

Dynamics: Three Stage Transition 4 3.5 3 2.5 2 1.5 1 0.5 D O Dynamics in Democracy(D) and Oligarchy(O) Private Capital State Capital 5 10 15 20 25 3 2.5 2 1.5 1 0.5 0 5 10 15 20 25 Private Firm Leverage State Labor 2 1.8 0.8 1.6 0.6 1.4 0.4 1.2 0.2 1 5 10 15 20 25 Time 0 5 10 15 20 25

Dynamics: Stage 1 2 Aggregate Output in Democracy and Oligarchy 1.8 1.6 Oligarchy 1.4 Democracy 1.2 1 0.8 5 10 15 20 25 Time

Stage 1: Rapid Growth Encourage private sector growth: η = η Low wage helps the growth of the private sector Rapid growth as the result of resource reallocation Benefit the middle-class Entrepreneurs benefit from low wage State workers get high wage

Dynamics: Stage 2 4 3.5 3 2.5 2 1.5 1 0.5 D O Dynamics in Democracy(D) and Oligarchy(O) Private Capital State Capital 5 10 15 20 25 3 2.5 2 1.5 1 0.5 0 5 10 15 20 25 Private Firm Leverage State Labor 2 1.8 0.8 1.6 0.6 1.4 0.4 1.2 0.2 1 5 10 15 20 25 Time 0 5 10 15 20 25

Dynamics: Stage 2 2 Aggregate Output in Democracy and Oligarchy 1.8 1.6 Oligarchy 1.4 Democracy 1.2 1 0.8 5 10 15 20 25 Time

Stage 2: State Capitalism State employment stops declining State investment increases Financial repression on private sector: η < η State investment drives growth Financial repression harms growth

Dynamics: Middle-income Trap (L = 0.2) 4 3.5 3 2.5 2 1.5 1 0.5 D O Dynamics in Democracy(D) and Oligarchy(O) Private Capital State Capital 5 10 15 20 25 3 2.5 2 1.5 1 0.5 0 5 10 15 20 25 Private Firm Leverage State Labor 2 1.8 0.8 1.6 0.6 1.4 0.4 1.2 0.2 1 5 10 15 20 25 Time 0 5 10 15 20 25

Dynamics: Middle-income Trap 2 Aggregate Output in Democracy and Oligarchy 1.8 1.6 Oligarchy 1.4 Democracy 1.2 1 0.8 5 10 15 20 25 Time

Stage 3, Case 1: Middle-income Trap L small (=0.2) Low cost to retain enough supporters Keep state employment at the critical level State capital grows at the same rate as the private capital Oligarchy is permanently sustained Low growth due to financial repression on private sector Persistent financial market friction

Dynamics: Sustained Growth (L = 0.4) Dynamics in Democracy(D) and Oligarchy(O) Private Capital State Capital 4 3 2 D O 4 3 2 1 1 5 10 15 20 25 30 0 5 10 15 20 25 30 Private Firm Leverage State Labor 2 1.8 0.8 1.6 0.6 1.4 0.4 1.2 0.2 1 5 10 15 20 25 30 Time 0 5 10 15 20 25 30

Dynamics: Sustained Growth Aggregate Output in Democracy and Oligarchy 2 1.8 1.6 1.4 Democracy 1.2 1 0.8 Oligarchy 5 10 15 20 25 30 Time

Stage 3, Case 2: Sustained Growth L large (=0.4) Too costly to maintain political support Elites choose to democratize State sector declines rapidly and private sector grows again Financial repression is removed Output grows to the high level in democracy

China: Now China has been transitioning from stage 1 rapid growth to stage 2 state capitalism Decline of state sector labor stops Overinvestment in the state sector

The State Advances as the Private Sector Retreats 1 Investment and Employment Share of the State Sector 0.9 0.8 0.7 0.6 Investment 0.5 0.4 Employment 0.3 0.2 0.1 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Year

Dynamic Implications Persistent labor market friction Persistent or even increasing capital market friction Capital Wedges between the State and Private Sectors 6.5 Difference of Costs for Capital 6 5.5 5 4.5 4 1990 1992 1994 1996 1998 2000 2002 2004 2006 Year

Dynamic Implications: Entrepreneurs Entrepreneur Lifetime Utility in Democracy and Oligarchy 14 16 18 20 22 24 26 28 30 32 34 Oligarchy Democracy 0.5 1 1.5 2 2.5 Entrepreneur Asset

China: Future Middle-income trap in stage 3 given the current conditions The calibration Z S Z P = 0.7 (Song and Hsieh 2013) L=0.2 τ = 0.1 (to match the state-private wage gap) β = 0.9 (to match the private sector labor growth) α = 0.5, r = 0.05 The state is politically and economically powerful

Extras: Reforms Previous analysis Given exogenous parameters: P = { L,η,Z S,... } Reform: change of the exogenous parameters Political reform: more rights for citizens and migrant workers Financial reform: free financial market State sector technology upgrade Conflicting interests: extractive elites v.s. technocrats max (V P (P) V)α (Y (P) Y ) 1 α

Political Reform More rights to citizens and migrant workers: Larger L Long run Output and Elite Income 120 100 Output Percent 80 60 40 Elite Income 20 0.15 0.2 0.25 0.3 0.35 0.4 Minimal Support Required

Political Reform Higher long-run output Democratization Harm elite interest Elites are against the reform

Financial Reform Increase the lower bound of loans to private firms: η Long run Output and Elite Income 110 100 Output Percent 90 80 Elite Income 70 60 1 1.5 2 2.5 3 3.5 4 Loans to Private Firms

Financial Reform Private firms get more loans Larger private sector Higher long-run output Harms elite interest because of a larger state sector Resistance from elites: Shanghai Pilot Free Trade Zone

State Sector Technology Upgrade Technology upgrade in the state sector: larger Z S Long run Output and Elite Income 180 160 Elite Income 140 Percent 120 100 80 Output 60 40 20 0 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 State Firm TFP

State Sector Technology Upgrade Less threat from private firms allows the government to relax the financial constraint Lead to higher efficiency and output Benefit the elites so it is supported by them

Other Countries Korea and Taiwan Growth in dictatorship before the 80s Democratization and sustained growth Politically connected large firms (chaebol in Korea) Kuwait Employment declined but then stayed or even reversed a bit in dictatorship 90% of adult Kuwaiti in public sector Migrant workers with low wages in private sector

Conclusion A theory of politico-economic transition Divide and rule strategy sustains oligarchy Explain rapid growth with labor and capital market frictions Growth is not sustainable in the current political system Democratization will sustain the growth In this critical juncture, reforms can be taken to sustain the growth

Appendix: Timing in Democracy 1. Capitals K S,K P are given 2. The government, controlled by the representative worker, decides tax rate τ D on the income of elites and entrepreneurs 3. Competitive equilibrium 4. Elites and entrepreneurs decide whether to hide the income at the cost rate τ 5. Tax income is transferred to workers

Oligarchy: Timing 1. Capital K S,K P are given 2. The government, controlled by the representative elite, announces the tax rate τ S on private entrepreneurs and private workers 3. The government sets minimal wage in the state sector w S 4. S and P firms hire L S and L P, separately 5. Workers in S and P sectors decide to support oligarchy or not, sequentially 5.1 supporters L: oligarchy is sustained 5.2 otherwise, democratization occurs 6. Firms produce. Pre-tax incomes are distributed 7. Entrepreneurs and private workers decide whether to hide the income at the cost τ 8. Tax income is transferred to elites

Democracy Solution Competitive equilibrium w D S = (1 α)(zk S ) α( L D S) α = w D P =(1 α)k α P Workers income: y D w = w D + τ D( Y S w D S LD S + Y P w D P LD P ) ( ) α L D P Elites income: y D e = (1 τ D)( Y S w D S LD S )

Oligarchy Solution Firms: w S w P = (1 α)(zk S ) α L α = (1 α)k α P L α P, S, The representative elite s income in oligarchy y e (L S )=π S (L S )+ τy P (L S ) s.t. w S (L S ) y D w L S L The two political constraint are equivalent to s.t. L L S L