Manufacturing bias disservice to future

| Professor Jenny Xu 14 Aug 2019

Jenny Xu, Associate Professor of Department of Economics, HKUST

Trade talks have faltered in recent months.

The United States maintains it has the upper hand being the bigger "buyer" in the relationship, while the Chinese argue the goods of lower costs it exports are doing a big favor to US consumers, who would ultimately suffer if the costs of such goods continue to rise because of tariffs.

While China is busy fighting the trade war externally, Beijing is concurrently trying to improve the efficiency of the economy to make it more robust and resilient in such difficult times.

An often-overlooked feature of Sino-US trade imbalances is that although Beijing runs up huge trade surpluses in the manufacturing sector, it has large deficits in the service sector.

These supply and demand mismatches suggest that there may exist inefficient misallocations in the Chinese economy.

Economic efficiency is achieved when factors of production in an economy are distributed or allocated to most productive firms or sectors with the highest demand.

In fact, the industrial sector in the Chinese economy is characterized by a vertical structure where state-owned-enterprises monopolize key sectors and markets in upstream industries, and provide intermediate goods to non-SOE downstream industries that produce manufacturer or service goods.

Due to policy distortions and regulations, severe resource misallocations exist between SOEs and non-SOE firms as well as the manufacturing and service sectors, which inhibits supply of services.

There is a wide range of policies to be adopted by Beijing that can help reduce distortions and financial friction in China.

First and foremost, banks should give more credit to private enterprises.

Empirical evidence shows private enterprises are more productive than SOEs.

Nevertheless, to make a loan to private firms, banks require a large amount of collateral, while there's much less restraint for lending to SOEs.

Wider availability of credit to private enterprises will increase the supply of service goods and reduce inefficiencies.

Another way is to reduce subsidies to upstream sectors (such as energy) which are dominated by SOEs.

The manufacturing sector usually uses more intermediate goods than the service sector.

With subsidies to these upstream sectors, the manufacturing sector has long enjoyed a cost advantage, and supplies excess goods that lead to trade imbalances and resource misallocations.

If subsidies to upstream sectors are rescinded or reduced, resources will then be shifted to services - a sector that is undeveloped in today's Chinese economy.

In a study conducted in the past two years by my team, we showed that policies that remove the subsidy on the SOE sector and alleviate the credit constraints on private firms in China will speed the economic transition up and reduce the trade imbalances by 39.3 percent, which will increase welfare by 14.7 percent, because resources are allocated more efficiently.

That is simply too much of a good thing to be ignored for so long.

It is obvious that a shift of focus to services will not cure all the ills of the Chinese economy right away, but policymakers ought to take the necessary steps to fix the country's economy as soon as possible.

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