By Shi Yaodong, Research Department of Industrial Economy of DRC

Research Report No. 136, 2008

The Chinese economy is currently at a major crossroad. The factors giving birth to the mode of China's fast economic growth, the internal and external environment, and the growth impetus and mechanism are undergoing a series of major changes. The original advantages of "infinite labor supply" and "low cost competition" are gradually phasing out. The resources and the environment find it increasingly difficult to support the process of industrialization that features high consumption and high emission. The ever-widening development gaps between different regions and between urban and rural areas are deviating from the aims of development, i.e. all-round social development and common prosperity. The external resources, the trade climate, the financial system and other destabilizing factors are making it more and more difficult for the Chinese economy to stay unaffected when the country is opening wider to the outside world.

Both the new period and the new situation require that the Chinese economy must change its mode of development as soon as possible. If it is to pursue a long and sustainable economic and social development, it must find a new development path, form a new development impetus, foster a new competitiveness and create a new system and mechanism environment.

I. Long-Term Challenges to Chinese Economy

1. End of an era with "infinite labor supply" and "low cost competition"

Half a century ago, Arthur Lewis, Economist on economic growth and development and Nobel Prize winner, introduced the theory of economic growth under the condition of "infinite labor supply". He noted that before achieving modernization, the developing countries with the typical characteristics of "dualist economy" could have an infinite labor supply at a subsistence wage level for a considerably long time, which would help realize long-term economic growth (Arthur Lewis, 1954). Because of China's economic restructuring and system evolution that began from the rural areas, the surplus labor that had long been confined to the low-efficient agricultural sector has been gradually released and has continued to flow to the nonagricultural sectors. This has given birth to an "infinite supply" of labor and a model of "low cost competition" (Liu Shijing, 2005). As a result, China successfully achieved an economic takeoff, with the average annual growth reaching 9.8%, and began moving toward a mature economy described by Walt Whitman Rostow.

As of 2002, however, the diverse factors that constituted the Chinese economic model of "low cost competition" began to change quietly:

First, the labor price in the east coastal region began to rise gradually due to the co-action of diverse factors, including the change in the labor market supply-demand relation, the gradual disappearance of "population dividend", the rise in the comparative advantage of agricultural production and the standardization of social security outlay. Accordingly, labor shortage began to spread from the high-qualified labor market (skilled workers) to the ordinary labor market (laborers) and from the coastal region to some inland provinces. Since the Labor Contract Law entered into force on January 1, 2008 which further standardized the legal relations between labor and management, the labor shortage and the rise of labor price have become ever serious. Labor disputes have also been on the rise.

Second, the tighter control over the land use for construction purpose, the introduction of the system on basic farmland protection and the reform of the land tender, auction and listing system have brought an end to the infinite and low-cost supply of land resources. As a result, land price has climbed up steeply.

Third, while the demand for imported crude oil, iron ore and other important resources continued to rise drastically, their domestic supply capacity continued to weaken. As a result, their CIF prices went up sharply year after year and in turn pushed up the prices of finished oil products, steel products and other downstream products.

Fourth, the market supply of coal, finished oil products, electricity and other energy products has experienced frequent shortages (coal shortage, oil shortage and electricity shortage) due to the coaction of the factors such as the rising demands, the increase in upstream costs, the insufficient transport capacities, the adjustment of controlled prices, and the natural disasters.

Fifth, the cost of environmental protection, long regarded as an exogenous variable of economic growth, has been gradually "internalized" by enterprises because the government has strengthened integrated environment protection according to law (such as collecting deposit funds for ecological environment compensation and intensifying punishment on environmental violations) .

Six, the accelerated revaluation of the Chinese currency yuan has weakened the price competitiveness of the export sector. Since China began the exchange rate reform on July 1, 2005, the yuan has revaluated by a total of 20%. This has brought an extremely unfavorable impact on the labor-intensive export processing sector.

Because of the piling up and coupling of the above factors, the Chinese economy inevitably bid farewell to the period of "infinite labor supply" and the era of "low cost competition" at the beginning of the new century.

2. Mode of growth featuring high consumption and high emission faces challenges

In recent years, the Chinese economy has paid a high price in the forms of resource consumption and environmental deterioration for maintaining a two-digit growth rate.

—The consumption of energies and resources has increased tangibly. While China's gross domestic product (GDP) accounts for about 5.5% of the global total , its share of global consumption is 31% for raw coal, 30% for iron ore, 27% for steel products, 25% for aluminum oxide and 40% for cement. China's total energy consumption for per 10,000-yuan GDP is three times the average level of the world, 4.3 times that of the United States, 7.7 times that of Germany and France, and 11.5 times that of Japan. China's domestic supply of some important mineral resources has been on the decline, with the crude oil's import dependency approaching 50%.

—The ecological carrying capacity has become more fragile. Because of the accelerated growth of the high-consuming and high-polluting industries, the Chinese economy has demonstrated a typical inverse Environmental Kuznets Curve (EKC). Land desertification, water pollution, pastureland degradation and forest damage have not been fundamentally contained. At the same time, natural disaster and extreme-climatic incidents have become more frequent, the greenhouse gas emission has been rising rapidly, the coal-based energy structure has aggravated the spread of acid rain coverage, and the urban smog has become ever more serious. In the ecologically fragile regions, the degradation of the environment and the life of poverty have failed to move out of their vicious circles.

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¹Based on the 2006 statistics of the World Bank and in reference to the China Statistical Summary 2008, China Statistical Publishing House, May 2008