China has a large untapped source of further growth: its vast state-owned assets, including enterprises, resources and land. Privatising these assets would unleash the wealth effect and boost domestic consumption. This reform would transform China's growth model from being investment and export-driven to being led by domestic consumption. It would reduce its over- dependence on industry and stimulate its service sector. At a time of a global slowdown, suchreform is timely.
When reform started in 1978, almost all productive assets were state-owned in China. But reforms since then have not included privatisation. Today the government owns more than 70 per cent of China's productive wealth. During the first 20 years of reform, concentrating the country's assets in government hands served a good development purpose, allowing the creation of infrastructure and expansion of industrial capacity. If state assets had been privatised, it might have been difficult for China to mobilise resources during the rapid industrialisation of the 1980s and 1990s. To the government's credit, the initial marketisation-without-privatisation approach has paid off. A robust infrastructure has emerged and China is an industrialised economy.
But this industry-first, government-investment-driven and export-oriented growth model has run its course. The focus on industry not services has damaged China's environment. It has also been highly resource intensive. China has expanded export markets beyond developed countries to include Latin America, the Middle East and Africa. But this past success is limiting the potential for further export growth. The slowdown, coupled with rising protectionism in the US and the global economy is not making export growth easy. To transform its economy, China needs to shift towards growth driven by domestic demand, not exports, and one led by services not industry.
What can stimulate such a transformation? Given that industrial capacity is already too high, privatisation is the answer. A decision to continue to concentrate resources in government hands would do more harm than good.
China's gross domestic product has been growing at more than 10 per cent a year, but its domestic consumption has been slow to catch up. Why?
This becomes less puzzling once we examine how past income and wealth gain are split between the government and households. First, the government's share in China's income has been rising at the expense of private citizens. From 1995 to 2007, the inflation-adjusted annual growth rate was 16 per cent for government tax revenues (not including state enterprise profits or proceeds from selling land usage rights), and 8 per cent and 6.2 per cent, respectively, for urban and rural household disposable income.In 2007, government tax revenues increased by 31 per cent but urban and rural disposable income went up by just 12.2 per cent and 9.5 per cent respectively. As private households' share in China's income pool is shrinking fast, consumption growth can only be slow.
However, the split in asset ownership between the government and households is even more damaging to consumption growth. It is true that 30 years of fast growth has enlarged China's income pool and dramatically increased asset values. Thus one would have expected a significant wealth effect on private consumption. However, with 70 plus per cent of this gain going to the government, private citizens have not been able to feel much of a wealth effect.
A wealth effect on private consumption is not possible unless consumers own more wealth. It is no surprise that all state-owned economies, whether China's or the Soviet Union's, have one thing in common: growth driven by investment, not consumption.
Therefore wages from labour are the main, or even the only, source of disposable income for most Chinese consumers. Even this single source is growing more slowly than expected. That is why private consumption is slow to rise. State ownership depresses consumption demand.
In addition, depending on whether the government or private households control the country's wealth and income, the economy will have a different demand structure. If households control spending power they will favour consumer goods and services, which benefits the service sector. If the government controls spending power, it will favour infrastructure, industrial projects and industrial goods, boosting heavy industries and energy and natural resource consumption.
In the 1980s and 1990s, these consequences of state ownership were growth-enhancing. Now, the over- investment in industry is a negative. It is fundamental for China to distribute ownership rights of the remaining state assets equally among its citizens. This private ownership would return the missing wealth effect to millions of families. In the short run, it would help maintain growth during a global slowdown. In the long run, it would improve China's industry/service sector mix, reduce its dependence on exports and also create more employment.
Yes, privatisation has created short-term disappointments in eastern Europe. However, it ran into challenges because it occurred in former socialist countries that had no prior experience with capital markets, mutual funds and the associated legal and regulatory structures. China has nearly two decades of experience in these. Its mutual fund industry manages more than 100m accounts. China is operationally ready.
The writer is professor of finance at the Yale School of Management