1. Human Capital Allocation, Technological Innovation and Sustainable Growth of the Chinese Economy Professor Weiying Zhang Guanghua School of Management Peking University 24 April, 2006 Stern School, NYU

2. Facts China’s economic growth has been astonishingly successful in the past 26 years; Average annual growth rate is 9.4%; The total GDP in 2004 is tenfold of that in 1978; Per capita GDP growth rate is 8.1%; Real per capita GDP of 2004 is more than sevenfold of 1978.

3. Source: 2005 China Statistical Yearbook

5. Questions Two Questions: –What is the main driving force for the high growth? –Could the high growth be sustained in future? I provide a simple framework to address the issues.

6. Allocative Efficiency and Productive Efficiency Two sources of growth: allocative efficiency and productive efficiency; Allocative Efficiency: production factors move from low productivity-low value sectors to high productivity-high value sectors; price must be right; Productive Efficiency: Increase in productivity through technological innovation; incentive for innovation must be right.

7. A B C Good 1 Good 2

8. Shift in the Sources The high growth in the past 26 years has been mainly driven by improvement in allocative efficiency, particularly reallocation of human capital; The potential of allocative efficiency is diminishing; probably for another 10 years; Sustainability of growth in future much depends on improvement in productive efficiency, that is, technological innovation.

9. Allocation of Human Capital Allocation of human capital is more important than stock of human capital! Talents and entrepreneurship can be used in different sectors (Baumol, 1990; Murphy, Shleifer and Vishny, 1994); What do most talented people do? Particularly, government or business? Economic development is determined by ability of businesspeople.

10. Types of Talents Allocation entrepreneurs bureaucrats workers high middle low bureaucrats entrepreneurs workers bureaucrats Type I Traditional China Type II Latin America Type II Developed countries

11. Reallocation of Human Capital In the history, China had “open government” and “closed businesses”; –Businessmen were ranked lowest in society. –Talented people went to government through imperial examinations; Change: from “best students go to government” to “best students go to business”;

12. Three waves 1980s: entrepreneurial peasants began entrepreneurial activities; TVEs development; 1990s: government officials and scholars went into business (xia hai), triggered by June 4 th Event; Around 2000, internet bubble attracted both overseas returned scholars and domestically best educated people to start-ups. From rent-seeking to value-creation;

13. Where Do PKU Undergraduates Go? Source ： Peking University’s Career Service Office

14. Education Levels of Chinese Managers Sources ： (1) Chinese Entrepreneur Survey System; (2) Reform Institute of China (1985 Survey);

22. Other reallocation factors Labor mobility: from peasants to workers; Industrial sector restructuring; Regional trade and division of labor; International trade; Foreign investments; …

23. Variation of Capital Productivities across provinces Source: Gong Liutang and Xie Danyang (2004)

24. Variation of Labor Productivities across Provinces Source: Gong Liutang and Xie Danyang (2004)

25. How Big Potential of allocative efficiency is Still, but diminishing; Business is still not free; entrepreneurs feel uncertain; Immigrant movement is a signal; Catch-up is easier (through imitation); further advancing is more difficult; Labor cost: China/USA: labor productivity is 1/6; labor wage is 1/42; so, labor cost is 1/7; But the labor cost advantage is diminishing very fast; high skilled labor markets are more globalized.

26. Source: 2005 China Statistical Yearbook

27. Challenges Sources of growth must shift from allocative efficiency to productive efficiency; This depends on technological innovation, R&D investments; Chinese enterprises: not much technology accumulation, low absorbability, low R&D investments and low incentives for innovation; Chinese entrepreneurs are good at imitation, but bad at innovation.

31. Source: 2005 China Statistical Yearbook on Science and Technology

33. Percentages of Advertising and R&D in Revenue with Firm Sizes in Manufacturing (2001-2003)

34. Percentage of Advertising and R&D in Revenue With Firm Ages in Manufacturing (2001-2003)

35. Advertising and R&D Expenditure in Pharmaceutical Industry (2003) USA: 10.5% (1997)

36. Communication, Computers and Other Electronic Equipments Note: 13 % of R&D to Revenue in US Computers

37. Source: 2004 China Statistical Yearbook.

38. Percentage of Firms with at least 1 patent in ZGC Science Park 2000200120022003 Hardware 5.8 ％ 4.0 ％ 2.4 ％ 3.7 ％ Software 1.7 ％ 1.5 ％ 2.3 ％ 1.0 ％ year Source: PKU e-Business Center, 2005

39. Consequences Since Chinese firms have no core technologies, entry barriers are very low, and price competition is very intensified! Thus, low market concentration ratios; Low profit margin.

40. Source: 2005 China E/I Industry Statistical Yearbook

42. Past is not a good guide for future Human capital reallocation has driven the high economic growth in the past 26 years! China faces new challenges! Economic growth cannot be sustained without significant progress in technological innovation!

43. Institutional Changes Needed Property rights protection and in particular IPP are fundamental for innovation; –It determines horizon of business people; –It direct directions of innovation (Petra Moser 2005,AER) Industry integration is needed for innovation; Deregulation and competition policy; Education system:

44. Cont’ Anti-corruption; Business norms For a successful transformation, China must continue to address institutional problems, particularly legal system: rule of law.

45. Thank you!