Since the start of the year, China’s overall economic situation has been worrying. Capital has been flowing out, supply chains have been disrupted, foreign trade has shrunk, the stock market has plummeted, and the Purchasing Managers' Index has hit new lows.
Amid the pessimism, the Chinese government announced plans to establish a unified national market, with an emphasis on unifying the basic rules in five areas: market operations; market connectivity; resources and key material markets; product and service markets; and fair market regulation.
This sounds like an inspiring plan, as the prevailing view is that the unified market will focus on the internal circulation of the economy. It will facilitate the circulation of capital, factors of production and commodities between regions in a way that reduces transaction costs, and is in line with the laws of the market economy.
In particular, the unified national market is seen as implementing Adam Smith’s classic theory of the division of labour through the removal of local protectionism and sector monopolies, thus greatly improving the operational efficiency of China’s markets.
It is difficult to raise objections amid loud praise. While having high hopes for the unified market, this article seeks to lay out the concerns of the move to spark more discussion and reduce the risk in policy implementation.
This article argues that there are three main problems with a unified national market: the negative impact on the economy, the violation of the theory of the second best, and the damage to China’s economic structure.
The unified national market will lead to a shift in capital and resources from the coastal areas to places with higher marginal returns. Such passive shifting is usually detrimental to some social groups...
Risk of structural unemployment
First, we look at the negative impact of a unified national market on the economy.
One of the disruptive realisations of the last decade in economics has been the realisation of the negative side of globalisation: lower international trade costs have exacerbated unemployment and widened the gap between the rich and the poor in developed economies.
As the objective of the unified national market is to build an internal circulation market with no barriers, it thus becomes a domestic version of a globalisation reform — naturally, there are concerns of similar consequences.
At the moment, much of China’s manufacturing sector is concentrated in the Yangtze River Delta and the Pearl River Delta. However, these regions will gradually lose their comparative advantage due to rising labour costs and lower connectivity to international markets.
The unified national market will lead to a shift in capital and resources from the coastal areas to places with higher marginal returns. Such passive shifting is usually detrimental to some social groups, for example, migrant workers who are already rooted or semi-rooted in the big cities.
For various reasons, it is difficult for these new migrants to follow the capital and move back to relatively less developed areas; meanwhile, the push towards internal circulation will lead to fewer suitable jobs for them. Hence, the first- and second-tier cities will most likely see rising structural unemployment and a widening gap between the rich and the poor.
This is a concern not only in the manufacturing sector of major cities, as structural unemployment could also happen in less developed regions. With the unification of the product and service markets, local service sectors that take in much of the local workforce would be more exposed to capital and technology risks.
In particular, less developed regions would be concerned with how the service sector could respond to competition from lower-cost, standardised, more automated services within the same sector, and how much unemployment this competition would cause.
Concentrated and overlapping investments
Besides structural unemployment, the existing industrial policies are another concern.
Under the banner of a “capable government”, over the past few years various regions have implemented countless industrial policies, but not all of which are strictly in line with improving comparative advantage. Instead, these policies repeatedly concentrate investments in the same few industries such as the digital sector, high-end equipment and new energy vehicles.
Under the requirements of the unified national market, resources and key materials would be even more concentrated. Where would these overlapping investments go?
It is clear that some regions would definitely lose out, and the absence of local barriers to protect them would only accelerate the process. This would then quickly — and more painfully — affect the common people.
Theory of the second best
Besides the string of practical questions, the unified national market also lacks thorough deliberation on a theoretical level. The crux is: what is the best fit? Is removing local barriers and breaking local protectionism the most effective path for China’s economy?
China’s local protectionism has evolved to be very sophisticated.
According to the widely applied economic theory of the second best, if it is not feasible to remove a particular market distortion, introducing one or more additional market distortions in an interdependent market may partially counteract the first, and lead to a more efficient outcome.
Classic examples include subsidising products with positive externalities (whereby their consumption or production benefits others), taxing products with negative externalities (whereby their production or consumption is detrimental to others), and tolerating some corruption in an imperfect market economy.
On their own, subsidies, taxes and corruption are distortions to a free market, but because there are other distortions (externalities or imperfect economic systems), these new distortions are necessary for market operations. Without them, market efficiency would decline.
So far, China’s local protectionism has evolved to be very sophisticated. Local governments no longer crudely ban the flow of key materials, products and capital, but protect local companies from external impact through a combination of customised entry criteria and government procurement.
The real concern of local governments is that if they do not set up appropriate barriers, their own income would be drastically reduced, and they would not be able to afford local public expenses.
While such local barriers are no longer a national phenomenon as compared with the 1980s and 1990s, they belie a deeper market distortion, the most important of which is the fiscal system that has been in place at the central and local levels since 1994. Under this system, there is a serious imbalance in the local governments’ financial authority and responsibilities, and they are unable to become financially self-sufficient.
The real concern of local governments is that if they do not set up appropriate barriers, their own income would be drastically reduced, and they would not be able to afford local public expenses.
Some academics are calling the current local protectionism a “prisoner’s dilemma”, that the local governments have overlooked the negative spillovers to other stakeholders while protecting themselves, thus affecting the overall economic efficiency. This description is a typical example of a “second best” situation.
While local protectionism is nothing to boast about, local governments are left with no other choice due to existing constraints. If we compare the Chinese economy to a pair of ripped jeans and local protectionism to a patch to mend the hole, the financial system is not the only hole in the jeans.
Local protectionism can also emerge from the promotion system for Chinese officials, an industry practice of blindly following instructions from the top, unclear property rights and so on. And these “holes” are waiting to be patched up by some form of local barrier.
Breaking up the M-form economic structure
Beyond practical concerns and theoretical considerations, the unified national market could have a serious impact on the current economic structure. Over the past 40 years, the main driver of China’s economic growth has been regional competition.
Various Chinese regions are able to compete with each other because of the multi-divisional form (M-form) hierarchy, which is the institutional foundation of the Chinese economy.
The M-form hierarchy can be understood as an economy made up of various blocks — separately, each of China’s individual local economies looks alike, and is equipped with a relatively well-developed industrial system that is self-sufficient to a certain extent.
This “generally similar but slightly different” economic structure fundamentally ensures the viability of regional competition. Undoubtedly, regional competition can lead to a loss of economic efficiency, but if there is no competition, China’s overall economic efficiency would be lagging far behind today, and our discussion would unfold at a completely different and much lower level.
As economic independence weakens within the region, various regions will have to mutually cooperate and stay interconnected instead of actively competing against each other.
As for China’s unified national market, the action plan to eliminate local protectionism, break down local barriers and unify products, services and factors of the market adheres to Smith’s theory of labour distribution. Under the unified national market, China’s M-form economic structure would be broken up, the process of differentiation among regional markets in China would be accelerated, and the originally comprehensive industrial structure of each region would become fragmented and specialised.
As economic independence weakens within the region, various regions will have to mutually cooperate and stay interconnected instead of actively competing against each other.
While there appears to be nothing wrong with what might happen, policymakers may have overlooked the fact that economic and political structures are always dialectically unified. With regard to the unified national market, society is mostly worried that the change in the economic structure could be followed by a corresponding change in the political structure.
A simple explanation proves this point: to maximise the flow of products, resources, services and capital across various regions, it is impossible to rely on the self-awareness of local governments.
The unified national market assumes that China would allocate the aforementioned resources through a market-based price mechanism, which would result in a redistribution of wealth among regions. The loss of profits would cause local governments to resist this change, with local officials needing to face the pressure of promotion at the same time.
Taken to extremes, it is also possible that regions would resort to fighting to the death over key resources. Hence, it remains a big question if the ideal price mechanism is still viable.
A more probable solution would be for the central government to form a more specialised department to undertake the corresponding coordination work in ensuring the smooth operation of the unified national market.
One possible solution is a high degree of political centralisation, with local officials becoming recipients and enforcers of orders. This implies that after the M-form hierarchy breaks apart, the motivation for regional competition disappears along with the change in economic structure.
A more probable solution would be for the central government to form a more specialised department to undertake the corresponding coordination work in ensuring the smooth operation of the unified national market. Also, the power of this department would exceed that of the local governments’ in terms of the distribution of resources, products, services and capital. Hence, the emergence of such a department would have a great impact on the distribution of political power between the central government and local governments.
As potential changes to China’s political structure would also bring about great uncertainties to the economy, the outside world is naturally debating the establishment of a unified national market.
Minimising short-term impact
In summary, I would describe the current situation as doing things by the book, as a unified national market may not suit China’s current situation although it is consistent with the classic economic theories of labour division and efficiency.
If it was implemented in strict accordance with what has been laid out, there would be greater economic risks in the short term and the country would have to prevent a series of problems such as structural unemployment, economic inequality and duplication of investments by local governments.
At the same time, the unified national market is an idealised optimal solution that does not satisfy the "second best" equilibria in the presence of constraints. If corresponding institutional flaws and theoretical distortions are not improved first, forcibly removing local barriers may not necessarily result in increased efficiency.
Most importantly, the unified national market would change China’s economic structure, resulting in the loss of the institutional foundation for regional competition and the motivation for local governments to compete with one another. It could also lead to a political restructuring in the future, triggering even greater systematic risks.
... the realisation of unified regional markets could be considered, such as the Yangtze River Delta, the Pearl River Delta, the Zhongyuan Urban Agglomeration (中原城市群) and so on...
While this article presents the challenges to the unified national market, it must be acknowledged that China made the proposal with good intentions. If it must be implemented, first, the realisation of unified regional markets could be considered, such as the Yangtze River Delta, the Pearl River Delta, the Zhongyuan Urban Agglomeration (中原城市群) and so on.
This is because similar resource endowments and industrial structures can effectively reduce unemployment and prevent excessive gaps between the rich and the poor. During this process, the coordinated allocation of financial resources within a region must also be taken into consideration and repetitive industrial policies must be reviewed to minimise the short-term impacts of the unified market.
Next, local protectionism should be regulated instead of removed. While a certain degree of local protection is inevitable, the central government can formulate rules targeting specific local protection policies, the extent of protection and exit mechanisms, thus restricting the behaviour of local governments through regulations.
Only by restraining the behaviour of local governments through long-term and committed rules can we reduce market fears of political intervention, enhance economic predictability and ultimately achieve the goal of boosting market confidence.
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