Some International Policy Issues for China
K. C. Fung
University of California
Santa Cruz, CA, USA
[email protected]
Nathalie Aminian
University of Rouen, 1 Rue Thomas Becket
76821 Mont-Saint-Aignan, France
Alicia Garcia-Herrero Chief Economist for Asia-Pacific, Natixis, ICC, Hong Kong
In this paper we provide a simple model of an emerging market like China. We
attempt to capture two characteristics of an emerging market: The simultaneous
presence of market failures and government failures. In this model, we study the
national welfare properties of four types of \governance" or \institutions": A Benevolent
Dictator, Extreme Economic Liberalism, Extreme Economic Nationalism
and Factional Fighting with groups pressuring the government. We also discuss a case of the Realistic Dictator, who may switch from adopting liberal policies to
nationalistic policies as the domestic market gets larger.
1. Introduction
As Europe is mired in uncertainties associated with the debt crisis and the
growth rate remains sluggish in the United States, a group of emerging
markets like China continues to perform relatively well economically. This is
particularly true if we look back at the economic performance over the last
few years. Based on market exchange rates, in 2007, China was the third
largest economy in the world, with Brazil being 10th, Russia 11th and India
12th. By 2014, China has emerged to be the second largest economy in the
world, with Brazil being 7th, India being 9th, Russia being 10th. In other
words, currently all four of the BRIC economies are among the top 10 largest
economies in the world.
Given the growing prominence of the BRIC and other emerging
economies, there is increasing interest in examining the past
experiences and future policy choices facing these fast-growing
countries, particularly China (Fung, 1998).
In this paper, we will select three international issues and provide
an analytical examination. First, the emerging economies are
often under the in°uence of protectionist/nationalist forces that
would like to further restrict trade. This seems to happen recently
in Brazil, which aims to make sure that its manufacturing industries
are protected as its exchange rate remains volatile. China is
also seen to be fostering its domestic companies via its \Indigenous
Innovation" policy. Economic nationalist sentiments seem to surge
recently also in Argentina, where the government was planning to
nationalize a Spanish-controlled oil company YPF (Webber and
Rathbone, 2012). As mentioned earlier, in China, since 2006, the
government has intermittently pursued an indigenous innovation
policy, with the aim focusing on helping the domestic ˉrms produce
higher value-added goods and spur more innovation from Chinese
ˉrms (Fung, 2015). In India, the government recently has to
withdraw or delay the implementation of allowing foreign retailers
to enter its domestic market. The arguments in favor of more trade
interventions typically point to the fact that most emerging markets
are still developing or middle-income countries. As developing
or middle-income countries, there is a much stronger likelihood
that there will be market imperfections. This may be due to
existing barriers to entry or failure to fully implement antitrust
laws. With failures of the markets, government and trade interventions
can theoretically be justiˉed.
There are also those who point out that most developing
countries lack high quality institutions, whether it is corruption,
insu±cient rule of law, nontransparent political decision-making,
etc. In other words, even in rapidly growing emerging countries,
government failures can also be present alongside with market
failures.
To incorporate these elements in our theoretical discussions, we
shall adopt a model where the government is pressured by two
factionsone by the reformers/liberals and the other by the
protectionists/nationalists. Formally, we depict this by adopting a
variant of the Grossman–Helpman model where the factions act as
pressure groups on the policymakers. The potential adoption of more trade intervention depends on the weights attached to the
\funding contribution" function. In this model, the government,
whether they are democratic or not, has an objective to maximize a
weighted sum of the \funds" or \bribes" it receives from the lobbying
factions and the general national welfare. For democratic
governments, this is interpreted to mean that the policymakers
want to maximize the chance it has for re-election. For non democratic
governments, this objective can be interpreted to mean that
the ruling elites care about their own interests, but they are enlightened
enough to pay attention to the national interest, or else
there will be large scale social unrests.
In addition, to capture a particular form of market failure, we
adopt a situation where the industries to be protected are characterized
by imperfect competition. In particular, we model the
industry to be oligopolistic so that trade intervention can theoretically
beneˉt the welfare of the country.
In the context of the presence of both market failures and government
failures, there are three factors to consider. The ˉrst one is a policy rule of free
trade, ignoring both government failures and market failures. This we can
interpret as \extreme liberalism." The second one is a policy conducted by a
benevolent dictator, who would just maximize the national welfare, ignoring
the pressures by the di?erent special interest factions. This can be illustrated by
a hypothetical all-wise benevolent dictator. The third is a democratic or more
representative government, open to in°uences of di?erent lobbying factions.
We will examine these cases in our analytical evaluation of the impact of these
di?erent \governance" cases on the welfare of the emerging country.
Finally, we consider a case where the government is more pro-active rather
than passive. The leaders and bureaucrats of the government directly derive
utility from having political power, in addition to receiving resources from the
liberal and nationalist factions. The government political power derives
partly from the ability to tax the national income, partly from the control of
licenses and regulatory regime. Over time, sources of national income changes.
In the case of China, the initial reforms focus on exports and opening up
to the outside world. But in this decade, the domestic economy has become so
large that it is often the case that protecting the domestic market will give the
government higher utility. For example, China's automobile market is the
largest in the world. China also accounts for about 20% of the global luxury
goods sales. At this stage of economic development, it may be rational for the
Chinese government to turn inward.
The organization of the rest is as follows. In Sec. 2, we will describe a model
of an emerging country like China with both market failures and government
failures. In Sec. 3, we will examine the welfare implications of the various
forms of governments and various policies: Benevolent Dictator, Factional
Fighting, Extreme Economic Liberalism and Extreme Economic Nationalism.
In the last section, we conclude.
2. A Model of an Emerging Market with Market Failures
and Government Failures
In this section, we will describe a basic model of the emerging country. We
consider an open emerging economy with two sectors: One formal sector and
one informal sector. The formal sector consists of two ˉrms: The exportcompeting
ˉrm produces good x for the foreign market and the importcompeting
ˉrm produces good y for the domestic market. The informal sector
produces the numeraire good n with a mobile factor only. The technology
for the numeraire good is constant return to scale. The goods, x and y are
produced with the mobile factor and a speciˉc factor. The mobile factor is
supplied inelastically to the domestic economy. As long as the informal sector is
active, the constant marginal product of the mobile factor ˉxes its economywide
return to unity.
Total population in the economy is normalized to one. A fraction x of the
population owns the speciˉc factor used in the production of good x and has a
direct stake in the export-competing ˉrm. This can be interpreted as the
liberal/reformer faction. A fraction y of the population owns the speciˉc
factor used in the production of good y and has a direct stake in the importcompeting
ˉrm. We can interpret this group as the conservative/nationalist
faction. The remaining 1 x y (hence after, m) individuals are the
owners of the mobile factor, which are used in both formal and informal
sectors, and earn a ˉxed return normalized to one.
The owners of the mobile factor are assumed to be inactive politically. For
example, they can be interpreted as the migrant workers in China, who have
limited political connections and likely cannot in°uence the policymakers
directly. Each individual is allowed to own at most one speciˉc factor.
Owners of the speciˉc factor organize as interest groups for political activity.
To capture the idea that emerging markets often have market failures, we
assume that the behavior of ˉrms in the formal sector is simple Nash quantity
duopoly (similar to the literature as in Brander and Spencer, 1985). This part
of the model is familiar to the strategic trade policy literature, but it is useful
for our expositions later in the paper. The exporting firm produces good x, and competes with the foreign, US ˉrm, which produces x in the US market.
The interpretation will be similar if we consider the case of China-Europe
trade (Fung, 2015; Aminian et al., 2015).
The exporting ˉrm from the emerging country charges px and maximizes
proˉt x and the foreign ˉrm fromthe developed economymaximizes proˉt x:
xex; x; tT ? xpxex t x cexT tx;
xex; xT ? xpxex t xT cexT;
e1T
where c and c are the costs of the exporting emergingmarket ˉrmand the foreign
developed economy ˉrm, each producing x and x, respectively. t is the protection
(in the form of a speciˉc tari?) imposed on the exports of the emerging
economy. After some simple algebra, we can show that a higher t will lower x.
This is the standard rent-shifting e?ect of a tari? in the presence of a market
imperfection in this case, an international duopoly. The liberal faction who
has a stake in the proˉts of the exporting ˉrms will like to seemore openness in its
trading partner.Furthermore, if through international negotiation, a lowering of
t is tied tomore openness in the emergingmarket, then the economic liberalswill
like to see less trade interventions in their own country.
The import-competing ˉrm in the emerging market produces good y and
competes with the exporting ˉrm from the established developed economy.
The import-competing emerging market ˉrm maximizes proˉt y and the
ˉrm from the developed country maximizes proˉt y:
yey; yT ? ypyey t yT cy; eyT;
yey; y; tT ? ypyey t yT cyeyT ty;
e2T
where cy and cy are the costs of the emerging market ˉrm and the developed
economy ˉrm producing y and y, respectively. Some algebra will show that
dy=dt > 0, i.e. trade protection will raise the domestic import-competing
ˉrm's proˉts.
With our oligopolistic structure of the tradable sector, trade protection by
the emerging country will raise emerging market ˉrm proˉts and reduce the
proˉts of the ˉrm from the developed country.
Turning now to the demand side, all individuals in the emerging country
have the same preferences and maximize the utility function:
Uien; Y cT ? ni t ueY ciT; e3T
where i ? x; y and m represents the shareholders of the export-competing
ˉrm, the import-competing ˉrm, and the owners of the mobile factor, respectively;
ni is the consumption of the numeraire good; Y ci ? yci t yci is
the total consumption of the homogeneous goods y and y by individual i.
The function Ue:T is di?erentiable, increasing and strictly concave in all
arguments. Utility is maximized subject to the budget constraint:
Ii ni t pyY ci; e4T
where Ii is the net income of individual i; py is the domestic price of good y.
From Eqs. (3) and (4), the indirect utility function of each individual in
group i has the form:
V i ? Ii t ueY ciT pyY ci
? Ii t CSepyT;
where i ? x; y and m; CS is consumer surplus derived from consumption
of the good in the import sector. For convenience, we assume that the
exportable good x is not consumed domestically.
The gross indirect utility functions for each individual in each group are
V x ? x
x
t CS; V y ? y
y
t CS; V m ? m
m
t CS;
where x and y are described in Eqs. (1) and (2); and m is the total ˉxed
return to the mobile factor. Taking the protection levels as given, the indirect
utility function identiˉes the utility level of an individual in group i when
there is no lobbying.
Given trade interventions, the gainers and the losers from an increase in the
intervention can be identiˉed, which further gives rise to the lobbying motives
of various groups in the emerging market. If the government does not pay
attention to the pressure by the economic liberals or the economic nationalists,
then the policymakers in the emerging country can choose an appropriate
level of the trade protection to maximize social welfare. With no lobbying or
factional pressures, the government's objective function is given by:
MaxtW ? axV x t ayV y t amV m;
whereW is the social welfare level which can be attained in the absence of any
political funds or contributions to the government. The socially optimal trade
protection is then given by tw ? arg maxW. This can be interpreted to be the
choice of the philosopher queen/Benevolent Dictator. But implicitly we assume
that the government o±cials derive no direct utility from in political
control. We will later amend this framework.
Formally, the lobbying structure follows Grossman and Helpman (1994),
Fung et al. (2007, 2010) and Aminian et al. (2012) framework. The two
pressure groups, as bidders, o?er various contribution schedules corresponding
to di?erent protection to the government of the emerging country
at the ˉrst stage. The government, as the auctioneer, sets the trade protection by evaluating the weighted sum of contributions and aggregate
social welfare at the second stage. An equilibrium is a set of contribution
schedules and the politically determined protection.
The equilibrium contribution schedules imply that the two factions make
contributions up to the point where the marginal beneˉt from the resulting
change in the trade protection exactly equals to the marginal contribution
costs. In equilibrium, the contribution schedules of each interest group are
given by:
aiV i
t
? ietT; e5T
where i ? x; y; ietT is the contribution schedule provided by interest group i
and they are di?erentiable at t.
The government's objective is to maximize the possibility of being reelected
or staying in power. With lobbying or factional pressures, other than
providing a high standard of living to the general public, the government has
another recourse to enhance its possibility of staying in power, i.e. the contributions
provided by the two factions. With lobbying, the government's
objective function contains not only the aggregate social welfare but also the
total level of political contributions or bribes. The maximization of the
objective function can be written as
MaxtV G ? e 1T?xetT t yetT tW; e6T
where > 1 represents the weight that the government puts on the
contributions provided by the interest groups.
The ˉrst-order condition of the government's optimization problem is:
V G
t
? eaxV x
t
t ayV y
t
T t amV m
t : e7T
The politically determined trade protection is given as tp ? arg max V G.
Simple algebra will show that the politically-determined protection will be
higher than the one picked by the welfare maximizing government. This is the
basic framework for a politically-determined protection in the presence of
market failures and government failures with two factions. This is the case of
Factional Fighting.
We can illustrate the welfare illustrations of the particular situations with
respect to our emerging country, China.
First, we have highlighted the case of an all-wise \Benevolent Dictator".
This is the case of a government that maximizes national welfare. This will
yield theoretically the highest welfare.
Second, we have a case where there is Factional Fighting with rival groups
vying to in°uence the government. In general, the protection is higher or
excessive compared to the case of a purely welfare maximizing government, i.e. compared to the case of a Benevolent Dictator. Economic welfare is lower
than that under the Benevolent Dictator, but higher than that with no trade.
For no trade, a prohibitive tari? is chosen so that imports y ? 0, which we
call Extreme Economic Nationalism. The last case is where trade protection is
set at zero, with t ? 0. This is the case of Extreme Economic Liberalism. But
under factional ˉghting, economic welfare can be higher or lower than that
under complete free trade.
We have our results:
Result 1. National economic welfare is highest with the Benevolent Dictator.
Extreme Economic Nationalism yields the lowest economic welfare.
Result 2. Factional Fighting and Extreme Economic Liberalism have intermediate
national economic welfare.
In reality, it is di±cult to ˉnd completely sel°ess governments anywhere,
whether in developing countries or in developed economies. So we consider a
case where the Benevolent Dictator may not be totally benevolent. The
government bureaucrats may have their own utility derived from being in
power. The regulators and the bureaucrats derive utility over the ability to
tax and to regulate the economy. We can posit that the government direct
utility Z(.) Under this Realistic Dictator, the government maximizes
W ? Ze:T t axV x t ayV y t amV m. We argue that when China ˉrst opened
up in 1978, its main source of income and growth came from foreign investment
and some international trade (Fung, 1997), As China grows into the
second largest economy, its domestic market has become so big that the main
source of utility to the Realistic Dictator case switches from closer to being an
Extreme Economic Liberalism to an Extreme Economic Nationalism. This
may partly explain the change in attitude of the recent Chinese policies. In
the past, the emphasis was on openness. Now in 2015, the emphasis is much
more on nurturing domestic companies (including state-owned enterprises)
and protecting the immense domestic market. So we have:
Result 3. As the economy grows and as the main source of national income
switches more to the domestic market, Chinese policies moves from
closer to Extreme Economic Liberalism to closer to Extreme Economic
Nationalism.
3. Conclusion
In this paper, we construct a simple model of an emerging country like China
with both government failures and market failures. Given the rising importance of emerging markets, there is growing interests among academics
and policymakers examining the past experiences and current and future
policy challenges of these countries.
Using our model, we evaluate the welfare properties of four forms of
\governance" in the emerging countries: Extreme Economic Liberalism,
Extreme Economic Nationalism, a Benevolent Dictator and Factional
Fighting between the pressure groups.
We show that theoretically, a Benevolent Dictator yields the highest
national welfare. Extreme Economic Nationalism gives the lowest national
welfare. Factional Fighting and Extreme Economic Liberalism give intermediate
national welfare.
Finally, we consider a case where we believe that in reality few governments
anywhere are completely sel°ess. We posit that a Realistic Dictator
derives utility from the ability to tax and regulate the economy. As the
economy gets larger and as the source of national income shifts relatively
towards the domestic markets, then the Realistic Dictator will tend to switch
from policies that are closer to Extreme Economic Liberalism to Extreme
Economic Nationalism. This may partly explain why China is seen currently
to be turning more \nationalistic" and \protectionist."
See full paper here: https://www.researchgate.net/publication/282322344_Some_International_Policy_Issues_for_China_Chinese_Economic_Policy_Review_2015