Redressing Regional Economic Disparities in China - The Domestic Use of FTAs, the "Flying Geese" Pattern and ODA

Consulting Fellow, RIETI

Leaving the egalitarianism of the planned economy era behind it, China started to push ahead with market-opening policies that place priority on efficiency over equality under the banner of "allowing some to get rich first" raised by Deng Xiaoping in the late 1970s. Now, more than a quarter of a century later, people's lives have, on the whole, improved. However, as shown by the growing economic gap among China's regions, income distribution has become increasingly polarized (See chart). The Chinese government is striving to realize an "all-round well-off society" by 2020 so that the fruits of economic development can reach all of its citizens. In order to achieve this goal, regional economic disparities must be corrected through the promotion of "domestic free trade agreements," the introduction of "a domestic version of the 'flying geese' pattern" and providing "domestic official development assistance."

Chart: Per capita GDP by Province (2003)
Chart: Per capita GDP by Province (2003)

Domestic "FTAs"

In an attempt to stimulate its economy through market expansion, China is striving to sign free trade agreements with neighboring countries. Standard economic theory suggests that the greater the interdependence among members of an FTA, and the stronger the complementary relationships among them, the larger the "trade creation" effect will be. It is the various regions within China, rather than China and its neighbors, which meet these conditions most fully. However, regional trade barriers still exist in China, and it has yet to become a unified market. In order for the economy to develop further, China should vigorously pursue an FTA that brings together its own provinces before seeking such agreements with other countries. This would also help correct regional disparities.

In particular, if the barriers restricting the flow of labor, such as the household registration system, were to be removed, workers would most likely flow from inland and rural areas where wages are low to the coastal and urban areas that are rapidly industrializing. Production will increasingly become concentrated as a result, but income levels in the country will tend to equalize. This is because remittances by migrant workers can provide an important source of income for inland regions. In addition, the inflow of labor can help curb increases in wage levels in the coastal regions while in the inland regions the outflow of labor will help raise wages. More than 100 million people are already said to have become migrant workers, but because these people do not have permanent residentship in the places to which they have moved to work, they face various forms of discrimination including medical care, education for their children and social security. The current household registration system, which restricts the flow of people, must be revised to allow the free movement of people so that these problems can be corrected.

At the same time, as the famous factor price equalization theorem of international economics suggests, even within a country, once trade is liberalized, the price of production factors such as labor and capital in any two given regions tend to converge. In such a case, we see a division of labor in which China's capital-rich coastal regions specialize in the production of capital-intensive products while inland regions use their relatively abundant labor to specialize in the production of labor-intensive goods. Thus, while the labor of inland regions embedded in labor-intensive products moves to coastal regions, the capital of coastal regions embedded in capital-intensive products flows inland. This serves as a force to equalize the prices of these production factors in the same way as the actual movement of labor and capital.

The domestic "flying geese" pattern

Like the flow of labor from less developed to more developed regions, the flow of capital in the opposite direction also contribute to correcting regional disparities. China should strive to create a domestic version of the so-called "flying geese" pattern seen in Asia, where economic development spread from Japan to the NIEs to ASEAN and then to China via direct investment. Traditionally, the flying geese pattern has been discussed in the context of international relations, but in the case of a huge country like China, such a pattern can be formed among the eastern, central and western regions - which are at different stages of economic development. During the past 25 years, the coastal region that comprises eastern China has achieved high economic growth thanks to the production and export of labor-intensive products, but it will no doubt see a rise in wages and land prices and lose competitiveness in labor-intensive industries sooner or later. Then, not only foreign companies but also Chinese firms will have no choice but to shift their production bases through direct investment. Inland regions such as central and western China should become potential destinations for such investment.

The reason why foreign direct investment is concentrated in the coastal regions and has been slow to flow inland is the large gap in infrastructure. The transportation capacity of China's railways and roads is low, and not only is it difficult to transport parts inland, it is very costly to export finished goods from there. Thus, in order to realize a flying geese pattern within China, it is essential to improve the infrastructure of backward regions.

Domestic ODA

In addition to the free movement of goods, people and capital, the redistribution of tax revenue by the central government - something that can be called a domestic version of ODA - can also be effective in correcting regional disparities. China can refer to the experiences of Japan, which has been called "the only successful socialist country," in this respect.

Compared to China, regional economic disparities in Japan are small. This is largely thanks to the role played by the transfer of fiscal resources among regions through the "local allocation tax system". Under this system, some of the tax revenue collected by the central government is redistributed based on a set of criteria to local governments. The aim of this policy is to correct disparities in tax revenue among local governments to achieve a national minimum standard throughout the country.

There will likely be strong opposition to such a plan, because while some regions will benefit from income redistribution, others will suffer losses. However, when we consider the fact that the income gap in China has already reached levels that could lead to social unrest, the government must swiftly reform the tax system, focusing on strengthening its tax allocations to local governments, if it is to maintain stable growth.

* The author's title is that at the time of this column's writing. (April 5, 2005)

April 5, 2005

April 5, 2005