Why is a free press good for China’s economy?

Zhiwu Chen
Professor of Finance
Yale School of Management

June 15, 2005

China has recently stepped up efforts again to control the press and cyberspace speech, despite apparent signs of widespread corruption and corporate wrongdoings. What does this trend of increasing censorship mean for China’s economy? Or, can we make “dollars and cents” out of press freedom? Is media freedom really relevant for China when its economy seems to be growing at a breathless pace? For centuries, freedom of the press has been viewed as a fundamental political institution, providing crucial checks and balances on political authorities. Often overlooked, but equally important, is the role of the press in facilitating economic development and correcting economic and business corruption.

        China’s growth story has been impressive in many ways. Since its economic reform started in 1978, GDP growth has averaged more than 9% a year, raising per-capita GDP (purchasing-power-parity adjusted) from $338 to about $5000 in 2003. As a result, more than 200 million people have been lifted out of poverty. China’s urbanization ratio went from 16% in 1978 to its current 41.8%. While the global economy has been slowing down after the tech bubble, China’s economy has not only maintained its momentum, but also provided a powerful source of growth energy for many countries. The list of achievements can go on and on.

        In fact, the China experience is so uncommon that it has made many scholars and  commentators scratch their head: the “law matters” and “institutions matter” theses have been widely accepted in law and economics, forming the core of the “Washington consensus”, but China is not known for having reliable institutions and yet its growth story keeps growing. This seeming contradiction is often illustrated by contrasting China with India or recently transformed Eastern Europe. Unlike China, India has the right modern institutions, but its per-capita GDP only managed to grow from $560 in 1978 (versus China’s $338) to $2358 in 2000 (versus China’s $3976) . So, what is going on?

Manufacturing versus the Service Sector

        The answer lies in the industry structure of growth. As is known, the main drivers of China’s growth have been export-oriented manufacturing and construction (real estate and highway). Though these developments have boosted the service sector, the latter has not taken full advantage of the potential afforded by industrial growth. As of 2004, China’s GDP is 15.4% from agriculture, 51.1% from industry and 33.5% from the service sector. In contrast, the service sector share in GDP is 51% for India and 79.4% for the U.S. In fact, China’s service sector is one of the least developed among countries with more than one million population. Its economy depends heavily on the industrial sector, and as a result China’s growth requires much consumption of natural resources, especially energy. This industry structure of growth also explains why China’s GDP has been able to rise even without market-friendly institutions.

To see this, we can contrast manufacturing, the heart of China’s growth engine in recent decades, and financial services. In toy manufacturing, for example, what is traded is tangible. A buyer can inspect a toy car’s design, style and colors, in order to ascertain its quality and properties. He can also test it one or more times before purchasing. The information asymmetry between the manufacturer (or the seller) and the buyer is limited, though it always exists. Of course, legal enforcement of product liability would be desirable in such a case. However, without it, the toy buyer may still overcome legal deficiencies by inspecting and testing the toy “harder”. Besides, even if the buyer finds product deficiencies after the purchase, he may be able to “live with it” as long as the toy “still works”. Therefore, the tangibility of physical goods affords the buyer sufficient ability to lower his informational disadvantage and mitigate transactional risks.

In contrast, what is traded in a securities transaction (say, a stock) is a financial contract or a claim on cashflow. First, this contractual claim will be worth nothing if it is not backed by investor-friendly securities law and supportive procedural rules, or by an independent, effective judiciary. Second, precisely because of the intangible nature of a financial contract, its buyer is at a severe informational disadvantage: the claim being traded has no color, style, weight or flavor; neither can the buyer test-drive it. The buyer has to rely on the information disclosed by the issuer and provided by the media, to value the security. In this case, the uninhibited flow of information, unrestricted investigative reporting and free expression of opinions about the security issuer and related parties is critically important.

Markets in tangible goods depend much less on legal and informational institutions than markets in intangible services, especially financial services. Therefore, countries with undesirable institutions may only be able to develop by focusing on manufacturing and other tangible goods industries, whereas countries with a free press and reliable legal institutions can choose to focus on industry or the service sector, depending on which offers higher value added. This conclusion is also supportable by cross-country experience. To see this, I divide 106 countries into three equal-size groups according to their 1990 press freedom ratings as provided by the Freedom House and then calculate each group’s average service-sector GDP share. The result is that in 2002, the average service-sector share is 62.4% for free-press countries, 57.1% for countries in the middle, and 48.5% for countries with a non-free press. When I replace the service-sector GDP share by the service-sector value added per capita, the same pattern holds. Freedom of the press indeed facilitates the service sector's development by reducing information asymmetries among transacting parties, which brings confidence to the marketplace. Unbiased, complete information and knowledge enhances trust, and trust is fundamental to the development and deepening of a service market.

Understanding the different degrees of institutional dependence between the industry and the service sectors, we can now see why China’s growth story does not reject the “institutions matter” thesis. With its vast and cheap labor force, China has so far been able to take advantage of the industry sector’s low dependence on informational and legal institutions and grow its economy without adopting any significant political reform. However, this “hardware” approach to development is not sustainable and is being challenged already by China’s economic reality.

A free press is necessary for China’s future growth

Challenges to the hardware-oriented approach come from several fronts. First, its energy- and resources-heavy nature has not only pushed up world resource prices, causing many to predict supply crises on the horizon, but also produced severe environmental damages in China. Being the World Factory means heavy tolls on China’s environment. Many rivers and waterways are already unbearably polluted.

Second, being already a dominant exporter of textiles, apparels, machineries and electronics, China is facing tough hurdles in further increasing its market share in many manufactured goods. Trade issues have been frequently in the headlines in recent months.

Third, manufacturing can no longer create new jobs, and China can only count on the service sector for job creation. For example, while manufacturing output has been growing at more than 14% a year since 1978, manufacturing employment peaked at 98 million jobs in 1995 and has since declined to 83 million jobs in 2002. Increasing efficiency and technical sophistication will only further improve productivity and reduce manufacturing jobs. According to the Asian Development Bank, there are about 200 million unemployed peasants living in China’s countryside. The official urban unemployment rate has stayed around 3.6% for many years, with the true unemployment rate remaining a state secret. Nonetheless, each year adds 15 million new job seekers (including 3.5 million college graduates). Since the annual job creation rate is currently at 8 million, this means that each year increases the unemployed by 7 million (not including the newly lost jobs). The employment challenge is no small potatoe. Finally, China has long expressed a desire to move up the value chain and expand into the more profitable service sector.

All of these reasons lead to one obvious conclusion: China must develop its service sector further. Indeed, given that its service-sector GDP share is almost the lowest in the world, this does mean the service sector offers the greatest potential, especially when you have 1.3 billion people to service. But, as said above, developing the service sector requires reliable law enforcement, judicial independence and freedom of the press, institutions that have improved in recent years but still have a long way to go.

As a point of illustration, take Shanghai as an example. Before 1949, Shanghai was the financial center and international trade hub of China, with a booming service sector. After the reform and open-door policy started in 1978, the central government decided to re-make Shanghai the future financial center of Asia. For two decades, the government has basically channeled most, if not all, financial businesses to Shanghai. For instance, the first stock exchange was set up in Shanghai in December 1990; Since 2001, all new listings of corporate shares have to be on the Shanghai Stock Exchange; Foreign banks and financial firms have been encouraged to be located in Shanghai. However, even given all the efforts by the government’s “visible hand” to favor Shanghai, this largest city of China has only 47.5% of its GDP from the service sector in 2004. In fact, its service-sector share has declined by half a percentage point for each of the past two years. This decline has taken place even while the real estate market has been booming in Shanghai. The total value added of Shanghai’s financial service industry was 10% of GDP in 1995 and reached a high of about 15% in 2000, but has since declined to 10% of GDP again last year. A contributing factor to this trend is the struggling stock market that has not been able to recover since mid 2001. Thus, without improving the media and legal institutions, even the flagship services-oriented city of China cannot get its service sector moving.

Institutional reform is the only way to go

The Chinese government has maintained a separation of economic development from politics by resisting political reforms. The political press has been tightly censored, while the financial press has enjoyed degrees of freedom up to some undefined ambiguous limit. But, in a country where state-owned enterprises still dominate the economy and where government regulations are everywhere intrusive and un-checked by a representative congress, it is extremely difficult to separate business matters from politics.

For example, with the governors of state-owned commercial banks being minister-rank political appointees, investigative reporting on their conducts and whereabouts is often restricted and subject to political censorship. While there has been a heated debate on financial risks and bank non-performing loans for many years, the exact extent of non-performing loans remains a state secret. Corporate governance of publicly listed companies has received much attention in China, especially after the Enron scandal. But, again, with the vast majority of the 1300 public corporations being majority-owned by the state, top management is mostly appointed by the government. Journalists have to face an uncertain career and/or litigation prospect if they dare to investigate and report on these corporations in a negative light. News editors are told to print positive stories, not negative ones, so as to present a positive picture about the economy and financial markets. Censorship limits the supply of useful information and distorts the information available in the marketplace, which hinders the development of markets, especially information-sensitive financial markets.

Unlike any time in Chinese history, today’s extensive highway, railroad and airway networks have truly integrated regions of China into one national market. Goods and services are sold beyond geographical boundaries. Stocks, bonds, insurance and other financial products are traded and held across regions. The potential damages to consumers and investors of wrong-doings by corporate managers and service/product providers can be geographically, socially and economically extensive. In such an extensive, complex market economy, no government can employ enough regulators and watchers to monitor, uncover and correct wrongdoings in the market place. Neither can the government do enough to provide sufficient and complete information on the market. A free and unfiltered press can not only play an independent role in providing information, but also have incentives to act as a corrective mechanism for the economy in a way that the government can’t. Thus, freedom of the press is not only politically necessary, but also has profitable implications for economic growth and job creation.