Justin Yifu Lin on economy, innovation, common prosperity, middle income trap, etc.

"Importation, Digestion, & Absorption" still key for China: former World Bank SVP & Chief Economist

Your Pekingnologist reached out to Prof. Lin and is very privileged to have him go over the translation, where he made slight revisions.

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The 60th China Economic Observation (CEO), with the theme of “Interpretation of the Two Sessions and China's Economic Prospects”, was held by the National School of Development (NSD) of Peking University on March 15th, 2022.

Professor Justin Yifu LIN, also Dean of the Institute of New Structural Economics at Peking University, spoke at the event. You will read the term New Structural Economics a number of times below, so here is a brief official introduction

Proposed and championed by Prof. Justin Yifu Lin and his collaborators, New Structural Economics is a theory of economic development, transition, and operation. Guided by historical materialism, NSE applies the neoclassical approach to the study of the determinants of economic structure and their evolution. The starting point of analysis is factor endowments and their structure which are given at any specific time and changeable over time. Technology and industry that determine the productivity of the economy are endogenously determined by the endowment structure, and the appropriate infrastructure and institutions which determine the transaction costs depend on the technology and industry of the eoncomy. NSE maintains that developing countries or regions should develop industries that conform to their comparative advantages based on their factor endowments structure. It seeks synergies between an effective market and a facilitating government in an effort to achieve economic transformation and upgrading as well as economic and social development.

This newsletter is a translation of the transcript published on March 21 on the web page [Chinese] of NSD. The original title is 林毅夫：中国经济增速新目标、增长法宝与共同富裕 Justin Yifu Lin: China's new economic growth target, the formula for growth, and common prosperity.

(ICYMI: A few days ago Pekingnology published the speech on the Chinese economy by Prof. YAO Yang, Dean of NSD, at the same event.)

Prof. LIN was the Senior Vice President and Chief Economist of the World Bank from 2008 to 2012. Prior to that, he served for 15 years as Founding Director and Professor of the China Centre for Economic Research (CCER) at Peking University.

LIN is a Counsellor of the State Council, China’s government cabinet. Lin is also a member of the National Standing Committee, Chinese People’s Political Consultation Conference (CPPCC).

I am more than glad, as a CPPCC National Standing Committee member, to take this opportunity to talk to you about some of the hot issues of concern to the delegates and representatives in the “Two Sessions” which just ended.

There are many hot issues, among which I would like to focus on three points: this year's economic growth target, innovation and development, and common prosperity.

Setting a GDP growth target of 5.5% is reasonable and realistic

I attach great importance to our economic growth rate. For China, the economic growth rate is the biggest picture and of the greatest political significance.

Why? First and foremost, we want to build a new development paradigm [Pekingnology] with a large domestic circulation as the mainstay [SCMP]. The larger the economy is, and the higher the share of the service sector is, the greater the share of the domestic circulation in the economy is bound to be. So, how to make the economy bigger and increase the share of the service sector? The answer lies in raising income, which requires economic growth.

Second, we need to keep in mind both domestic and international imperatives: the overall strategic picture of the great rejuvenation of the Chinese nation, and the big picture of the profound changes unseen in a century.

The economy lays the groundwork for the realization of the great rejuvenation, though such the great rejuvenation also entails many other aspects such as politics and culture. In my opinion, in achieving the great rejuvenation, a goal that’s not excessively high involves setting a goal of reaching 50% of the U.S. GDP per capita at purchasing power parity (PPP), which is basically South Korea vis-a-vis the U.S. in 2002. However, our current GDP per capita at PPP is just over 20% of that of the U.S.. Going from just over 20% to 50%, and hopefully achieving that by 2049, surely requires a relatively high economic growth rate.

Another big picture is the profound changes unseen in a century [Yuan Peng, CICIR] [Rush Doshi]. One important reason is the changing world economic landscape as a result of the rise of China. So, how to pull off our best game amidst the changes? From my perspective, the key lies in China's GDP per capita at PPP reaching 50% of that of the U.S. Only then will the U.S. be convinced to acknowledge China as the world's number one economy. Because, by then, our economy will be twice the size of the U.S., which will be a fact that can’t be altered.

GDP per capita and industry and technological capabilities in Beijing, Tianjin, Shanghai, and the five developed coastal provinces in the east will be on par with the United States at that time, which would make no space for the U.S. domination in the “chokehold ”technologies [NYT]. More than that, trade is a win-win situation, and smaller economies benefit more than larger ones. Large corporations in the U.S. need China’s large market to maintain their positions in the world’s economy, and the U.S. domestic market needs China's large market to boost employment, raise people’s living standards, and sustain its own domestic development.

The above all shows that development is the foundation and key to solving all our problems in China, including the challenges posed by the profound changes unseen in the century.

I have said repeatedly that China has a growth potential of 8% per year by 2035. I should emphasize that I am talking about the "potential" for growth. What does growth potential mean? It’s like when you buy a car, you look at the maximum speed that the car is capable of by design. Growth potential is the rate of economic growth that can be sustained from a technical point of view, without causing inflation and over-consuming resources for future development. The fact that we have a growth potential of 8% per year until 2035 does not mean that we must grow at 8% every year. Just like a car designed to reach a maximum speed of 300 kilometers/hour doesn’t do 300 km/h every time we drive it. The actual speed can be affected by the weather, road conditions, and the driver’s physical conditions, among other factors. Therefore, In the process of development, although an 8% growth potential suggests a possibility, we must also consider the influences of a range of domestic and international factors.

I argued on many occasions that, with the 8% growth potential, we should be able to achieve a 6% annual growth by 2035, considering factors such as building a new development paradigm, achieving the great rejuvenation of the Chinese nation, and navigating the profound changes unseen in a century.

This year's government work report set the 5.5% target, lower than I expected. This target setting, I believe, is realistic in the current situation. The 8% growth potential and the 6% growth rate are measured under a hypothetical situation where there was no Russo-Ukrainian war. The prices of oil, food, and mineral resources skyrocketed globally after the war broke out. The U.S. sanctions against Russia pose great uncertainty to the international financial system. These factors will certainly affect the import and development costs of China, the largest importer of oil, and the most important importer of food and raw materials. Therefore, I believe it’s reasonable and realistic to set out a target of around 5.5%.

China’s GDP now accounts for more than 18% of the global economy. Even with a 5.5% growth rate, China could still contribute one percentage point to the world economic growth, accounting for 25% of the global economic growth. We, while being well-positioned to maintain our own economic development, will continue to be the main driving force of the world’s economic growth.

We have proposed to stabilize growth [New York Times], as the Central Economic Work Conference re-emphasized [Pekingnology] that development is the basis and key to solving all the problems. Perhaps we can do a bit more to exceed 5.5%, bringing it closer to 6%.

Innovation based on importation, digestion, and absorption is what we can’t do without

The purpose of economic development is to raise income levels and improve the quality of life of the people. Then, economic growth cannot be achieved in the “old-fashioned” way, which is based only on the low-level expansion of factor input. There must be innovation so that an increasingly higher level of labor productivity can become the major driving force of development.

The question is how to innovate? The academic community and media usually emphasize new inventions when talking about innovation. In the academic community, innovation is quantified by total factor productivity (TFP) which basically measures the contribution of the invention to growth. Such thinking and theoretical frameworks are actually influenced by the mainstream economics we read. Let's be clear that mainstream economics comes from developed countries, where technology is already the best in the world. In that case, to innovate, it has to be new inventions. Moreover, the added value of industries in developed countries is already the highest in the world, which suggests that to upgrade industries, they can only rely on the creation of new industries.

As we all know, the invention is rather costly and risky, but investments in Research and Development (R&D）are not considered input factors when people do growth accounting. So, the much-admired TFP is actually a residual term that cannot be explained by the increase in capital, labor, and other factor inputs in the growth accounting. Yet this residual term couldn’t come out of thin air. It requires investment in new technologies and inventions.

Developed countries derive innovation from invention and their economic growth rates fluctuated between high and low in history. From the mid-19th century to now, the average growth rate of developed countries was about 3% per year - 2% of which came from the increase in GDP per capita or average labor productivity, and 1% from the population growth.

We are different from developed countries. We are still trying to catch up with them. For the countries that are still catching up, innovation does not mean exactly the same as in developed countries. This is because that innovation is nothing but the technology used in the next phase of production being better, or the added value of the industry entered in the next phase being higher, than the current one.

As mentioned earlier, given the most advanced technology and the highest value-added in developed countries, the invention is what it is called for to foster innovation. But for us as a developing country, many of our technologies are far from the best in the world, and there’s still a considerable gap between them and those in developed countries. Therefore, we can import and absorb the technology from developed countries as a source of innovation, which is relatively more cost-effective and less risky.

Likewise, we can also introduce, digest, and absorb the industries that are mature and have higher added value than ours from developed countries, which is another way to upgrade our industries. And this is usually less costly and risky than inventing new industries ourselves.

A developing country that knows how to use this approach will have a faster rate of technological innovation and industrial upgrading than developed countries, and its economy will grow faster. However, its total factor productivity (TFP) will be lower. This is because when importing technology, or mature industries, we purchase equipment of more sophisticated technology, and these investments are reflected in increases in capital, leaving the residual item - TFP - appearing lower in growth accounting than in developed countries.

We need to break the myth of TFP. Importation, digestion, and absorption as the mechanism of innovation are major driving forces for developing countries to grow at relatively high speed and low cost. In fact, since the Reform and Opening-up, how much of the over 9 percentage points of our average annual growth has been achieved by inventing new technologies and industries ourselves? We shouldn’t say there aren’t any, but the vast majority of the annual growth comes from importation, digestion, absorption, and re-innovation. This is not only true for China, but also for Japan and the United States when they were in the catching-up stage, with bigger economic growth rates and smaller TFPs.

Now the academic community has this discussion that says China has been using the method of importing, digesting, and absorbing technological innovations to promote economic growth for more than 40 years, and that, in 2021, our per capita GDP reached US$12,551, moving China towards the edge of a high-income country. Does it mean that we don’t have further opportunities for importation, digestion, and absorption? Do we have to invent technologies all by ourselves? Do we have to pursue a TFP-led innovation approach to economic development, as the media and academic community often say nowadays?

To address this issue, let’s look at the actual economic situation in our country. From the perspective of the new structural economics, I divide China’s current industries into five major categories.

The first category is industries that are still catching up, i.e. industries that we have and developed countries have, but their technologies and output are better.

The second category is the industries where China already hit the top in fields such as home appliances and 5G telecommunication, among others.

The third category is industries in transition, during which we have lost the comparative advantage which we had in the past when we had taken the lead, for example, in some labor-intensive industries.

Fourth, the “over-taking” new economy industries such as artificial intelligence and big data. They give us the opportunity to overtake developed countries because the new economy has a particularly short R&D cycle and is based on human capital investment. We start at the same place as developed countries in R&D of the new economy. Given that they are driven by human capital and that China is a country rich in human capital with a large domestic market and full industrial chain, we have an advantage in the field and can compete directly with developed countries.

The fifth category is strategic industries - industries that developed countries have but we do not and that we cannot import due to reasons in national defense and economic security, among others. We have no choice but to invent the industries by ourselves or else we will be choked off.

According to the new structural economics, there are these five types of industries, each taking up a certain proportion of the economy. In fact, the majority of our industries are still in the catching-up category.

For instance, in 2021, China’s high-tech manufacturing sector accounted for 15.1% of the entire manufacturing sector, leaving a proportion of 85% in traditional industries and other relatively mature traditional industries. In the case of the Hannover Messe, according to media reports, there are a total of 27 exhibition halls this year and Chinese products are present in every one of them. However, the prices of Chinese products in most of them are much lower than those of other countries. Why? Because there’s a huge gap between the quality and technological level of our products and those of developed countries. The vast majority of our industries are still catching up. And the best way to close the gap in technological innovation is to learn, digest, absorb, and re-invent, which is the key for developing countries to achieve rapid development.

Recently, the General Secretary told a story [Pekingnology]. I heard the same story when I was in primary school in Taiwan because it was first told by Sun Yat-sun.

There was a laborer who lived by moving things for people with a bamboo stick [across his shoulder]. One day he bought a lottery ticket and hid the ticket in a bamboo stick. When he suddenly found out that his number had won the jackpot, he was so happy that he threw the bamboo stick into the river, thinking that he would never have to do this kind of hard labor again in his life. Only when he arrived at the lottery office did he realize that the lottery ticket had been thrown into the river with the bamboo stick.

The General Secretary told it when talking about China's energy transformation, suggesting that, as we’re rich in traditional energy sources, we cannot abandon all of them at once before new energy sources have been fully developed.  

By the same token, the importation, digestion, absorption, and re-invention method should entail 85% of our manufacturing industry. It’s a key that we cannot do without. I hope that the media will make clear this point and that the academic community will work out this theoretical framework. Otherwise, it would be a pity to lose the key to the rapid development and innovation we have achieved over the past 40 years.

The best way to common prosperity is to continue with the development conforming to comparative advantages

Entrepreneurs are essential to innovation, whether via independent R&D or importation, digestion, and absorption of existing technologies. They play an important role in fostering innovation in traditional industries and in other industries including those where we are leading, have the chance to over-take, strategic, or in transition (towards the smiling curve’s two ends). Although entrepreneurs face great risks in innovation, once they succeed, they will be rewarded with high returns in terms of income, a necessary incentive for entrepreneurship.  

No one will be motivated to pursue innovation if it doesn’t bring successful entrepreneurs high returns. If there’s no innovation, economic growth will slow down, which, in turn, makes it very difficult to achieve the great rejuvenation of the Chinese nation and to pull off our best game in the profound changes unseen in a century.

Common prosperity has been widely discussed lately. We’ve been, in fact, determined in pursuing common prosperity since Day One. Despite this, doubts have emerged, both at home and abroad, whether common prosperity means killing the rich to benefit the poor [Reuters] and whether each individual is going to be paid the same account of money. If that’s where we’re going, it certainly will hinder entrepreneurship, raising doubts over China’s future development.  

Does common prosperity inevitably lead to the sacrifice of entrepreneurship? Not exactly. It depends on the way to achieve common prosperity.

From the perspective of new structural economics, if we follow the comparative advantage in technological innovation and industrial upgrading, we can achieve a balance between fairness and efficiency in the primary distribution and give the government more space for secondary distribution [OECD]. Why? If we act on our comparative advantage, we will have the lowest cost of production, and competitive advantage will be formed under the joint action of an efficient market and facilitating government. This, of course, will lead us to efficiency.

The income of the poor mainly comes from labor, while the income of the rich, is capital gains.  If we innovate according to our comparative advantage and form a competitive advantage, we can increase employment to the largest extent, which will be a pro-poor development.

Moreover, once our comparative advantage brings along competitive advantage, China’s economic growth will be faster and so will the capital accumulation. Over time, capital will change from a relative shortage to a relative abundance, and labor will go quite the other way round. When this change in factor endowment structure occurs, the wages of labor will rise very fast and the asset with comparative advantage (labor) owned by the poor will become more and more valuable; conversely, the relative return of capital will decrease, and so will the value of the asset with comparative advantage owned by the rich. This will lead to an improvement in income distribution.

Several countries in East Asia, when in the catch-up phase, boosted economic growth while ensuring fair distribution. I have also done a lot of empirical studies in China, finding that if a region acts on its comparative advantage, faster economic growth and fairer income distribution can be achieved at the same time, which brings along the unity of fairness and efficiency.

Furthermore, if the economy grows fast, the government will have more revenue, and if we develop our country conforming to comparative advantage, companies then will be viable, without relying on the government's protection subsidies. This way, a larger portion of the government's increased revenue can be used in the secondary distribution and invested in education that provides human capital for the labor force, giving them higher employability. This can, in turn, eliminate regional and urban-rural disparities and takes care of underprivileged groups in the society, further improving income distribution.

Before 2007, the academic community at home and the government emphasized the efficiency in primary distribution and the fairness in secondary distribution, which was the old saying. In the past, when we talked about the importance of efficiency in the primary distribution, we often used technical indicators, thinking that the more intensive in capital and technology, the more efficient. In fact, this is not the case. Acting on our comparative advantages can bring us the greatest competitiveness and efficiency.

In early 2007, I made several reports and published an article [Chinese] in the People's Daily, arguing that the development conforming to comparative advantage can achieve the unity of fairness and efficiency in the primary distribution. I was very glad that the 17th CPC National Congress held in October 2007 changed the previous expression, 一次分配重视效率，二次分配重视公平 “primary distribution emphasizes efficiency and secondary distribution emphasizes fairness”, to 初次分配和再分配都要处理好效率和公平的关系，再分配更加注重公平 “a proper balance will be struck between efficiency and fairness in both primary distribution and redistribution, with particular emphasis on fairness in redistribution.” [Chinese] That is basically the concept of new structural economics that I have been talking about.

If we develop conforming to comparative advantage, the economy will develop very fast, accompanied by very fast structural changes. There will be some business geniuses who will seize the opportunity of the structural transformation. In addition, the new economy that gives us the opportunity to overtake will allow us to stand with developed countries and invent from the same starting line, and there will also be some geniuses in technology who will seize the opportunity of innovation.

Both types of geniuses can become super-rich in a very short period of time, which will widen the income distribution gap. The money is only a number for the super-rich, and they can't use them up. If we have a better tax system to encourage the rich to donate and establish a good social atmosphere to respect their contributions to society, we can further achieve fairness through the third distribution [China Daily].

Therefore, I believe that in order to achieve common prosperity, the most important thing is to innovate conforming to comparative advantages and implement the goal set by the 17th CPC National Congress to give consideration to fairness and efficiency during primary distribution and make the cake bigger and the division of the cake more equitable. That can then be supplemented by secondary and third distribution.

China is about to cross the high-income threshold

Finally, when will China cross the high-income threshold and become a high-income country?  

In 2021, China’s GDP per capita reached $12,551 [Global Times]. Before July 2021, the threshold for a high-income country in the world was $12,535 [World Bank]. If we use that threshold, we became a high-income country last year. But in July 2021, the World Bank and the United Nations made an adjustment. The new threshold for high-income countries is now $12,695 [World Bank], and China is only 1.8 percentage points away from the new threshold.

if we achieve a growth of about 5.5% this year, and if the exchange rate does not change much, China should be able to cross the threshold this year and become a high-income country. Of course, $12,695 is based on the current exchange rate, and the exchange rate will fluctuate. I think no matter how it fluctuates if we don’t cross this threshold this year, we would cross it next year, and I believe, in the absence of dramatic changes in the internal and external environment, at the latest, we will be able to cross it in 2025 when the 14th Five-Year Plan is completed.

Crossing this threshold is of course an important milestone in the great rejuvenation of the Chinese nation, and we are very fortunate to have moved from being one of the world’s poorest countries to a high-income country. This is not only an important milestone in the great rejuvenation of the Chinese nation but also an important milestone in human economic history.

In 1900, the population of the Eight-Nation Alliance accounted for 23% of the world. In the past 100 years, the developing countries had faster population growth than developed countries, but lower economic growth, so they could not cross the threshold.

Up to now, the population living in high-income countries only accounts for 16% of the world’s population. If China also becomes a high-income country, the world’s population living in high-income countries will double, from 16% to 34%.

I believe that we will have the opportunity to witness this chapter of history.

(ICYMI: A few days ago Pekingnology published the speech on the Chinese economy by Prof. YAO Yang, Dean of NSD, at the same event.)

Lin (Lynn) Liu, a student pursuing a Master's degree in international journalism at Tsinghua University, contributed to the translation.