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China | The Advantage of Backwardness

Posted By Robert On Friday, August 22nd, 2014 With 0 Comments

China has become a source of debate and concern amongst investors around the world. So what is all the fuss about?

 

Fact 1: From 1979 to 2014 (current) China achieved a 9.9% annual growth rate which has never been observed in any other country in history.

Fact 2: Investors and experts have predicted a slow down in China’s growth every year for the past 30 years.

Fact 3: One day they will be right.

China is now the largest exporting country in the World and second to the USA in status for being the largest trading country in the world.

So how was it possible to achieve this sort of growth rate?

Prior to the 18th century, with the growth rate at the time, it would have taken 1400 years to double the average income of the West. After the 18th century growth rates grew at an exponential rate – bringing the term of doubling the average income from 1400 years to 35 years. The catalyst for this was the Industrial Revolution.

The rate of technological changes accelerated which meant improved productivity  –  which leads to improved income. The rate of technological advancement accelerated so the rate of growth did too.

The cost of technological innovation in high income countries required high capital input which corresponded to high risk. In a developing country such as China, technological imitation came with a much lower cost and a reduced risk. If a developing country knows how to tap into technological innovations, growth can be 100-200% higher.

China - Advantage of Backwardness

Why only after 1979?

In 1950s, Socialist governments took over China, their aim was to overtake Britain in 10 years and catch the USA within 15. Prior to the 1970s, industries China wanted to tap into was under patent protection, causing this very expensive to license.

So even if China wanted to buy to license it was impossible. So China had to ‘reinvent the wheels’ to develop, the cost of which would be equal if not more risky in a high income country. Those kind of advanced capital intense inventories was not a competitive advantage of China’s economy as prior to the 1970s it was a poor country. China’s competitive advantage was with labour intensive industries.

So it was not until after 1979 that China began to tap into this competative advantage. It was clear that for China to achieve dynamic economic growth – they needed to engage in labour intensive production and then export to richer nations. This strategy was implemented in other socialist countries and almost every developing country by WW2.

China versus Germany

The reason why the developing world was backwards is because they didn’t have the modern inventories, if they wanted to catch up the high income countries they need to own those kind of modern inventories, so their policies will not work.

In 1980-1990s almost every developing country engaged in economic transition from heavy government intervention to a way of functioning market economies. Except for China, Vietnam and a few others almost all countries during the transitional period encountered some kind of collapse in their economies and they stagnated for some time.

The consensus at the time was the reason why developing countries could not do as well as high income countries because they did not have similar market institutions.

Policy recipe was to implement privatisation, marketisation and liberalisation simultaneously. At the time this was thought as the only way to move a developing country to a market economy.

Protecting non-viable firms in old priority sectors – if the government removed all distortions immediately – all those firms (because they are not viable) in a market economy are going to collapse.

If they collapse it will create 30-40% unemployment, the majority of which is likely to be in more urban areas. No country will be able to achieve social and political stability with these sorts of unemployment rates. (The targeted unemployment rate for the UK is currently 7%).

Point of Money

The China Approach

If you understand that the firms in the older priority sectors was not viable – if you want to avoid the collapse, it’s important for the government to provide some sort of transnational protection to maintain stability. You then will want to move to liberalise entry into the sectors which consist with that country’s competitive advantages which was repressed in the past.

The government facilitates the entry of the private sectors directly into those new sectors and since they are consistent with the competitive advantage of the economy they become very competitive. The growth in those sectors can tap into the advantage of backwardness. This economic growth creates a condition for the reform of the older sectors which is why China could stabilise and grow.

That's wasn't Chicken

A common misconception is that China owes it’s prosperity to exports, through some regime of export orientation. In fact, investment is the central plank of China’s growth model. By keeping its currency cheap – therefore ensuring imported consumer goods are expensive – and offering very weak social protection, it encourages extremely high rates of savings, more than 50% of national income in 2011.

This means it has a correspondingly sky-high level of investment, much of which is funnelled through state-owned enterprises.  There are pros and cons to the state control of China’s investment. The negatives are that it often squandered on building cities where few people want to live. On the other hand, a large portion of it has been devoted to infrastructure that has positive externalise for the economy’s productivity – including the world’s largest high-speed rail network.

China and North Korea

The state has also been canny in using its bargaining power to extract technology transfers from developed countries. It lures Western investors with the promise of its large and growing market, but then requires them to invest in joint ventures with local firms, ensuring that advanced production methods spread around the economy. As a result, an economy regarded as primitive a generation ago now boasts some of the world’s leading technology firms such as Huawei, the telecoms giant.

Can other developing countries ‘Do a China’?

80% of the world’s population is still in the developing countries. If they can develop their economies according to their competitive advantages to maintain competitiveness and tap into the potential of the advantage of backwardness. Every developing country in the world should have the potential to maintain 8% or more growth rate continuously for one generation or more, just like China, developing their country from low income status to medium or high income status within one or two generations.

Made in China

What is the Advantage of Backwardness?

The advantage of backwardness refers to developing countries that are of low income, these types of economies have traits that are advantageous over high income countries. The obvious would be the fact that labour is cheap in these nations. Many foreign companies can outsource their production to poor companies for cheaper labour. Whilst technologies are sought within their own countries to replace human production with machinery (think self-scanning tills in Tesco).

Other advantages of backwardness would include investment, much like the example above for China, investment opportunities may arise like transport infrastructure where in high income countries this investment has already been made.

One thing that is often over-looked with the advantage of backwardness is that for there to be an advantage, there must be other advanced countries present. Japan, China and Indian would not have experienced the growth that they did if it was not for more established countries. So it is international inequality that is an essential part to the advantage of backwardness as advanced countries offer opportunities of backwardness.

The final example of where advantages of backwardness occur is with innovation and imitation as we mentioned above. Advanced countries would possibly invest huge amounts of capital into research, trial and error and general labour of developers to create a new technology.

Where as poorer countries without the appropriate human capital may not be able to find the resources and finances to innovate. Therefore they can concentrate on imitating wealthy countries innovations and use their technologies at a fraction of the price.

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