CHINA
22 March 2014
China's productivity deficit
Even after more than three decades of stellar growth, China's productivity is only 13 per cent that of the US. Why? And how can China make up the lost ground?
The pace and scale of China's economic transformation have no historical precedent. And yet, since 1978, China's productivity has risen from 3 per cent of the US level to only 13 per cent. An excellent paper by the University of Toronto's Xiaodong Zhu provides insights into these issues.
How did China slip so far behind?
Some 900 years ago, China was the world's leading economic power. But according to economic historian Angus Maddison, China started to fall behind Western Europe by the end of the 15th century. The more centralized and inward-looking political systems of the Ming and Qing dynasties would have stifled innovation and commercial activities in China.
In the "Great Divergence", Kenneth Pomeranz argues that even in the eighteenth century, living standards and commerce in China's Lower Yangzi region were comparable to those in the richest parts of Europe, and that China only started to fall behind Western Europe after the Industrial Revolution.
In any event, a great divergence did occur between China and Western Europe in the nineteenth century and the first half of the twentieth century. This was instigated by an imperial political-institutional system that protected vested interests of elite groups -- like imperial households, members of bureaucracy and local gentry -- who in turn were resistant to adoptions of new technologies.
China then continued to be weakened by civil unrest, opium wars, Sino-Japanese war, foreign occupation of parts of China, second world war, and civil war. China's per capita GDP declined between 1800 and 1950.
What about the Mao period? In the Mao Zedong period, from 1952 to 1978, China did achieve economic growth, despite the disasters of the great leap forward and the cultural revolution. An annual growth rate of 3 per cent per capita (about the same as the US) was driven mainly by large scale investment and a rising capital output ratio, and to a lesser extent an increase in human capital. Productivity actually declined during this period, reflecting the great inefficiency of the state-planned economy.
From 1978 to 2007, the reform period, China achieved a much higher rate of growth, annually about 8 per cent per capita. Many policy reforms were implemented to move towards a market economy -- liberalization, privatization and opening up to international trade and investment. But the government retained and indeed strengthened a large number of state-owned enterprises (SOEs) which are active in strategic sectors.
Productivity growth has been the motor of this growth, accounting for three-quarters of the growth. Increases in human capital and the labor participation rate have made relatively minor contributions.
How was such a rapid improvement in productivity possible? China's reforms removed many distortions that unleashed productive potential. The country has also been able to absorb foreign knowledge and technology. And when the reform period started, China was so far behind that it could not help but move up quickly.
According to Xiaodong Zhu's calculations, investment has not played a role because the capital output ratio has been basically unchanged through the reform period. This is in sharp contrast to discussions in the popular press where it is contended that China has relied on investment-driven growth -- the share of investment in China's GDP has risen from 27 per cent in 1978 to around 50 per cent today.
How can we square this dilemma? Like many other governments at the time, Mao's government thought that the fast track to development was through massive investment in heavy industry such as steel, concrete and heavy machinery. The country's comparative advantage wasn't given a second thought. This was an ill-considered move for such a poor country like China, and resulted in a capital output ratio that was "too high". These inefficiencies resulted in negative productivity growth during this period.
Ideally the reform era should have promoted greater efficiencies in investment, and the capital output ratio should really have fallen back. But it did not -- the return on investment in many SOEs and on white elephant infrastructure projects is still very low.
Thus, the high rate of investment that has kept the capital output ratio constant, represents a continuation of excessive and inefficient investment. In fact, China's capital output ratio is higher than America's even though China's natural comparative advantage is in labor intensive production.
Xiaodong Zhu projects that even if China can replicate its extraordinary growth performance for another two decades, its productivity performance would still be only 40 per cent of the US level -- well below the level of Japan in the 1950s or Korea and Taiwan in the 1960s.
China has many opportunities for raising productivity growth -- as Nobel Prize winner Robert Solow taught us, persistent economic growth can only come from productivity. And in the cases of Japan, Korea and Taiwan, productivity growth did not slow down until it had reached about 60% of the US level.
China also needs to dramatically improve its productivity since it faces a rapidly ageing and then declining population. Also, as it runs out of surplus labor, wages have also been increasing sharply.
Reforms in the financial and enterprise sectors will be key to continued productivity improvement. China's banking sector is still dominated by the state-controlled banks that lend disproportionately to local governments and SOEs. The new private sector (especially SMEs) can't get finance from the official banking sector and has to rely on family/friends, internal sources or the emerging shadow banking sector. The banking sector needs to operate on a commercial basis, providing funds to the best enterprises, and the whole finance sector needs to be opened to new players.
The SOEs continue to enjoy substantial monopoly rights in many areas from energy, transportation and telecommunications to banking, entertainment, education and healthcare. This is because the reform process has been designed to the benefit of key interest groups in the state sector (members of the Communist Party and their families and connections) such as by giving monopoly rights to state-controlled or politically connected firms.
This has facilitated the reform process, but resulted in corruption and income inequality, as well as economic distortions. It remains to be seen whether the Chinese government is able to introduce competition and reduce distortions in these sectors by making the necessary reforms. Unfortunately, the state is now a more pervasive force in the economy than a decade ago.
It seems very possible that, as in the Ming and Qing dynasties, elite vested interests (beneficiaries of the status quo) could stifle progress in reform. Where will this end up? No-one knows. But revolutions often occur when things are getting better, but where people are still not happy!
Executive Director
Asian Century Institute
www.asiancenturyinstitute.com
How did China slip so far behind?
Some 900 years ago, China was the world's leading economic power. But according to economic historian Angus Maddison, China started to fall behind Western Europe by the end of the 15th century. The more centralized and inward-looking political systems of the Ming and Qing dynasties would have stifled innovation and commercial activities in China.
In the "Great Divergence", Kenneth Pomeranz argues that even in the eighteenth century, living standards and commerce in China's Lower Yangzi region were comparable to those in the richest parts of Europe, and that China only started to fall behind Western Europe after the Industrial Revolution.
In any event, a great divergence did occur between China and Western Europe in the nineteenth century and the first half of the twentieth century. This was instigated by an imperial political-institutional system that protected vested interests of elite groups -- like imperial households, members of bureaucracy and local gentry -- who in turn were resistant to adoptions of new technologies.
China then continued to be weakened by civil unrest, opium wars, Sino-Japanese war, foreign occupation of parts of China, second world war, and civil war. China's per capita GDP declined between 1800 and 1950.
What about the Mao period? In the Mao Zedong period, from 1952 to 1978, China did achieve economic growth, despite the disasters of the great leap forward and the cultural revolution. An annual growth rate of 3 per cent per capita (about the same as the US) was driven mainly by large scale investment and a rising capital output ratio, and to a lesser extent an increase in human capital. Productivity actually declined during this period, reflecting the great inefficiency of the state-planned economy.
From 1978 to 2007, the reform period, China achieved a much higher rate of growth, annually about 8 per cent per capita. Many policy reforms were implemented to move towards a market economy -- liberalization, privatization and opening up to international trade and investment. But the government retained and indeed strengthened a large number of state-owned enterprises (SOEs) which are active in strategic sectors.
Productivity growth has been the motor of this growth, accounting for three-quarters of the growth. Increases in human capital and the labor participation rate have made relatively minor contributions.
How was such a rapid improvement in productivity possible? China's reforms removed many distortions that unleashed productive potential. The country has also been able to absorb foreign knowledge and technology. And when the reform period started, China was so far behind that it could not help but move up quickly.
According to Xiaodong Zhu's calculations, investment has not played a role because the capital output ratio has been basically unchanged through the reform period. This is in sharp contrast to discussions in the popular press where it is contended that China has relied on investment-driven growth -- the share of investment in China's GDP has risen from 27 per cent in 1978 to around 50 per cent today.
How can we square this dilemma? Like many other governments at the time, Mao's government thought that the fast track to development was through massive investment in heavy industry such as steel, concrete and heavy machinery. The country's comparative advantage wasn't given a second thought. This was an ill-considered move for such a poor country like China, and resulted in a capital output ratio that was "too high". These inefficiencies resulted in negative productivity growth during this period.
Ideally the reform era should have promoted greater efficiencies in investment, and the capital output ratio should really have fallen back. But it did not -- the return on investment in many SOEs and on white elephant infrastructure projects is still very low.
Thus, the high rate of investment that has kept the capital output ratio constant, represents a continuation of excessive and inefficient investment. In fact, China's capital output ratio is higher than America's even though China's natural comparative advantage is in labor intensive production.
Xiaodong Zhu projects that even if China can replicate its extraordinary growth performance for another two decades, its productivity performance would still be only 40 per cent of the US level -- well below the level of Japan in the 1950s or Korea and Taiwan in the 1960s.
China has many opportunities for raising productivity growth -- as Nobel Prize winner Robert Solow taught us, persistent economic growth can only come from productivity. And in the cases of Japan, Korea and Taiwan, productivity growth did not slow down until it had reached about 60% of the US level.
China also needs to dramatically improve its productivity since it faces a rapidly ageing and then declining population. Also, as it runs out of surplus labor, wages have also been increasing sharply.
Reforms in the financial and enterprise sectors will be key to continued productivity improvement. China's banking sector is still dominated by the state-controlled banks that lend disproportionately to local governments and SOEs. The new private sector (especially SMEs) can't get finance from the official banking sector and has to rely on family/friends, internal sources or the emerging shadow banking sector. The banking sector needs to operate on a commercial basis, providing funds to the best enterprises, and the whole finance sector needs to be opened to new players.
The SOEs continue to enjoy substantial monopoly rights in many areas from energy, transportation and telecommunications to banking, entertainment, education and healthcare. This is because the reform process has been designed to the benefit of key interest groups in the state sector (members of the Communist Party and their families and connections) such as by giving monopoly rights to state-controlled or politically connected firms.
This has facilitated the reform process, but resulted in corruption and income inequality, as well as economic distortions. It remains to be seen whether the Chinese government is able to introduce competition and reduce distortions in these sectors by making the necessary reforms. Unfortunately, the state is now a more pervasive force in the economy than a decade ago.
It seems very possible that, as in the Ming and Qing dynasties, elite vested interests (beneficiaries of the status quo) could stifle progress in reform. Where will this end up? No-one knows. But revolutions often occur when things are getting better, but where people are still not happy!
Author
John WestExecutive Director
Asian Century Institute
www.asiancenturyinstitute.com