China's planned entry into the service sector

The Chinese don't do things halfway, as anyone who's visited Beijing in the run-up to the Olympics can attest. So when China's economic planners decided recently to begin shifting the foundations of the Chinese economy from manufacturing to services, you might expect the country would embrace the shift with similar single-minded enthusiasm. And on the surface, it has. But as Chinese government policymakers and businesspeople are learning, decreeing a service sector into existence doesn't necessarily make it so. China's move from manufacturing to services was the topic of a panel discussion at the Fifth Annual Shanghai National Accounting Institute-Arizona State University Executive Forum.

The Chinese don't do things halfway, as anyone who's visited Beijing in the run-up to the Olympics can attest. The whole city has been given a once over. State-of-the-art glass and steel buildings have replaced centuries-old ramshackle courtyard houses, a newly revamped and expanded public transportation system snakes above and below the city's resurfaced roads, and a carefully groomed populace can now greet foreign visitors in their native language.

So when China's economic planners decided recently to begin shifting the foundations of the Chinese economy from manufacturing to services, you might expect the country would embrace the shift with similar single-minded enthusiasm.

And on the surface, it has, with China measuring itself nightly in the news against India, hosting academic symposia and service expos, and pumping money and propaganda into the country's major cities at an unprecedented rate. But as Chinese government policymakers and businesspeople are learning, decreeing a service sector into existence doesn't necessarily make it so.

Role of financial markets

"China is advocating more invention and innovation," Tu Guangshao, Shanghai's vice mayor and one of the principal architects of China's economic development, recently told an audience of Chinese business and policy leaders at a panel discussion at the Fifth Annual Shanghai National Accounting Institute-Arizona State University Executive Forum. All the attendees nodded sagely in agreement.

Eric Maskin, the Albert O. Hirschman Professor at the Institute of Advanced Study at Princeton and 2007 Nobel Laureate in Economics, pointed out that while government policy is important, the real key to a shift away from manufacturing lies in the development of sophisticated financial markets.

"Service economies are driven by ideas, how to make things better, how to provide better services, but typically the people who have these ideas don't have the capital themselves to carry these ideas out," he explained. "Financial markets provide the resources that enable these ideas to get put into practice. And that's why the financial sector is critical to the success of any economy."

And while Vice Mayor Tu agreed that China's financial markets could benefit from a reduction in centralized legislative regulation and more sophisticated participation from private and institutional investors, the truth is that the central government's economic regulation has begun to undermine the very development it seeks to encourage.

Panelist Bai Chong-En, chair of the economics department at Qinghua University, described the frustrations of a colleague who works in venture capital for a Chinese State-Owned Enterprise (SOE): "I'm too constrained," his colleague told him, "even in possession of the same information, I am not allowed to take the same risks as a private venture capitalist."

And according to Bai, such risks are essential for the healthy development of a service economy. "There are no sure bets in financial markets. There is a lot of uncertainty because they depend largely on emerging companies and technologies," he said. "There's just too much going on for the Chinese government to exercise centralized control over the country's financial markets."

Up to the government to decide?

Everywhere there are signs that despite the government's sincere desire to modernize the economy, it is still unwilling to relinquish its control. Take the State Administration of Radio, Film, and Television's recent month-long cat-and-mouse game with the big three Chinese YouTube clones, for instance. Speculation among Chinese media watchers was that SARFT was sending the heavily invested startups a clear message: venture capital or not, we're still the boss.

Such regulatory squabbling is counterproductive and ultimately self-defeating, argued Lin Zhou, the W. P. Carey Professor of Economics at the W. P. Carey School. "Allowing market forces greater play allows market development to happen almost spontaneously." Citing as an example Shanghai's recently redeveloped Bund, Zhou said, "Under the government's custody, the city's most notable real estate became virtually worthless as the grand waterfront buildings were used as makeshift factories or allowed to crumble.

The opening up of the real estate market reinvigorated the Bund, spontaneously raising real estate prices and transforming it from a dingy manufacturing district into a grand avenue of bustling businesses and restaurants." But beyond the question of whether it is possible for a centrally planned economy to develop the thriving financial markets required to shift from manufacturing to services looms an even larger question: is it up to the government to decide?

Maskin seemed to think not. "I'm not sure that this is a matter that has to be decided at a governmental or collective level. Being an economist, I'm a firm believer in letting the market make many economic decisions. As far as whether to go towards manufacturing or go towards services, I see that as largely a market decision," he said.

Steering toward what?

Chinese leaders, however, are not leaving anything to chance. China's service revolution has begun, according to government officials, starting with the economic boomtown of Shanghai. "Shanghai will develop its service sector, specifically its financial and shipping services," said Vice Mayor Tu. But more than a policy directive, only a suitable and sustainable economic environment can ultimately change the mindset and actions of the private and public sectors, argued Bai.

Outside China's major coastal cities, for example, local governments remain focused on short-term revenue from manufacturing projects. "Now we are in the post-industrial age. However, China still suffers from tremendous economic disparities. Local governments are still focused on manufacturing while more advanced regions are moving from manufacturing to services," Vice Mayor Tu said.

Provincial governments pursue manufacturing projects because they still lack concrete incentives to make the shift. "Despite the central government paying lip service to the transformation of the economy, local governments are still being pressured to produce rapid return on investment, and rapid return on investment comes from big power plants, not from the service industry," Professor Bai said. Only real incentives — in the form of investment, tax relief, or subsidies — can help build a stronger service sector.

"Rather than creating a financial market, you should let it grow naturally. Government's role should be creating the prerequisites of development — a skilled workforce, for instance — the areas in which there is just not enough incentive for the private sector to invest," said Zhou. Bai agreed, urging "the Chinese government should reduce its interference in the financial sector and focus instead on providing it with a good institutional and regulatory environment," Bai said.

But officials like Vice Mayor Tu don't see regulation as interference; they see it as an essential safeguard against the uncertainties of the market. "We're still a young economy, we're still very vulnerable to external forces," said Tu. To him, the benefits of strict central regulation greatly outweigh its disadvantages.

Citing China's weathering of the Asian financial crisis of 1997 and the recent global slump caused by the housing crisis in the United States, he shrugged away fellow panelists' appeals for hurried deregulation saying, "Only good regulation will allow China to open its financial markets any further." Can central planning really produce a healthy and dynamic financial market and service sector?

Despite raised eyebrows from the West, Chinese officials seem to think that it can, though they admit the Chinese service sector won't develop in exactly the same way as it has elsewhere. "China is a big country that is difficult to steer," said Tu, falling back on the mantra of Beijing's economic planners. And as the economy develops further, it's only going to get more difficult.

Bottom Line:

• China's centrally regulated approach to economic development may hit a snag in its most recent shift to a service-based economy.
• Strong financial markets are essential to a thriving service economy — funding market innovations and inventions.
• Over-regulation of financial markets limits needed investment in emerging markets and technologies.
• Chinese economic policymakers see the drawbacks of central planning but feel the greater stability it provides outweighs them.
• Despite a lot of fanfare trumpeting China's move from manufacturing to services, few actual changes have taken place.