Combating China's Export Contraction: Fiscal Expansion or Accelerated Industrial Reform?

Initially, the global financial crisis caused a surge of financial inflows, raising Chinese investment but this abated in 2008, to be replaced by a slowdown in export demand. The government's key response has been to commit to an unprecedented fiscal expansion. Two oft-ignored consequences are, first that government spending is on non-traded goods and services and so enlarges the consequent real appreciation and, second, that a more inward-looking economy causes firms to face less elastic demand and hence to increase oligopoly rents, further enlarging the real appreciation. Both are important for China because of the contribution of its real-exchange-rate sensitive, low-margin labour-intensive export sector to total employment. An economy-wide analysis is offered, using a model that takes explicit account of oligopoly behaviour. The results suggest that a conventional fiscal expansion would further contract the Chinese economy and, moreover, that the structural changes required would be considerable and painful. On the other hand, accelerated industrial reform, emphasising the sectors that remain dominated by state-owned oligopoly firms, would reduce costs and foster further export led growth in both output and modern sector employment.