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Inception Workshop, Beijing 31 May 2010

CHINA TOWARD AND UPPER MIDDLE-INCOME COUNTRY: CHALLENGES AND POLICY
OPTIONS
Session 3, Education, Labor and Income Distribution

Good afternoon Ladies and Gentlemen!

I am very pleased to be here today to speak to you about the impact of demographic trends in
the labor market in China. I'd like to share a few views to complement Mr. Yang's excellent
presentation, but approaching the subject from a different perspective, population aging, which
is a major upcoming challenge in China.

In the last three decades, China has experienced the fastest demographic transition in the
world. The resulting demographic dividend doubled the size of the working-age population in a
short period of time, adding about 2 percentage points a year to GDP growth. However, this
accelerated demographic transition turned China into an aging society in the year 2000, at an
early stage of development, without solid safety nets, and at a low level of per capita income,
posing an enormous challenge. Since then, dependency ratios have increased, and the
demographic dividend is expected to peak in five years time, in 2015, to decline thereafter.

The resulting labor shortages will exert pressure on the labor market and depress GDP growth.
This is because labor shortfalls will increase labor costs, eroding China's competitiveness in
labor-intensive low-value-added manufacturing, benefiting China’s competitors. For instance,
the demographic dividend in India will peak much later, in 2040.

Overall, labor shortages without total factor productivity (TFP) increases depress GDP growth.
Western countries were the first to age, and solved the problem by shifting from input-driven

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growth models to productivity-driven ones. The same could be achieved in China, by
rebalancing the growth pattern to looking for new sources of productivity, which has been
already discussed in previous sessions, and by labor market reforms to increase the mobility
and the quality of the labor force.

There are several ways to increase the supply and the productivity of labor in China. Policy
actions conducive to greater labor mobility will reinforce employment generation. Existing
institutional barriers, and I am alluding here to the hukou system, and the limited portability of
labor-related benefits, hinder natural migration flows from labor-surplus provinces to labor-deficit
ones, and deter urbanization, a key source of growth, resulting in an inefficient allocation of
labor. Simulations suggest that transferring 10% of the labor force that is currently employed in
agriculture into other sectors, could add up to 6 percentage points to GDP growth.

Higher labor mobility should be underpinned with measures to increase the productivity of labor.
Upgrading the value added of manufacturing and services through higher investment in
research and development, (R&D), will increase productivity levels and offset competitiveness
losses vis-à-vis other countries. Yet, this process requires far-reaching reforms in the education
system, conducive to higher human capital standards, because to promote innovation-driven
growth, new skills and talents are needed. Further, an aged society requires new jobs for the
provision of goods and labor-intensive services to the elderly, which, in turn, implies training and
re-training the labor force. Let me give you an example to illustrate the point, in Germany, aging-
related adjustments in the labor market to accommodate changes in the consumption pattern,
will force over 15% of the working population to change jobs in the near future.

Rising retirement age will also increase labor supply. Retirement age in China was established
in 1950, when life expectancy was much lower than today. It was set at 60 years for men and at
55 years for women. Nowadays, with average life expectancy up to 75 years nationwide, and up
to 81 in large cities, retirement age in urban areas could be easily increased to 65 for men and
women, keeping women longer in the labor market also increases labor supply, and women
usually leave longer than men. A more flexible approach, however, should be taken in rural
areas, where conditions are different.

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There is an important point to be made here. The common perception that early retirement
eases unemployment is misleading. This is supported by many years of evidence in developed
economies, where early retirement has not reduced unemployment levels at all, but has
substantially increased pension-related costs and fiscal imbalances. Moreover, it should be
noted that efforts to reduce urban unemployment in China by encouraging early retirement will
be counterbalanced by migration flows from rural areas.

Finally, an open policy towards immigration from countries with younger populations, is the
fastest and the most direct way to increase labor supply. However, this measure requires a
comprehensive regulatory framework supporting the participation of foreign workers, including
lowering institutional and social barriers to immigration.