China has accomplished a remarkable feat in transforming itself from one of the world’s poorest countries to its second largest economy in just 30 years. Yet the determinants of its successful development are far from established or well understood. With so much debate happening now around the cause and trajectory of China’s slowdown, it’s worth focusing on what the evidence reveals about what has driven its growth in the past and what might keep the economy going in the years ahead.
Let’s first consider the productivity of capital and labor. What economists call “total-factor productivity” (TFP) measures how much output has been raised from those inputs of units of capital and workers. Some find evidence of a clear improvement of total factor productivity since market-oriented reforms began in 1979, estimating that the increase in TFP contributed about 40% to GDP growth, roughly the same as that contributed by fixed asset investment. There was also a slowdown in TFP after the mid 1990s. In 2005, the OECD estimated that annual TFP growth averaged 3.7% per annum during 1978-2003, but slowed to 2.8% by the end of that period.
Explanations for changes in TFP growth are often controversial, but China’s turn-of-the-century slowdown coincided with sluggish rural income growth and widespread industrial inefficiency as well as the waning effects of one-off re-allocations of capital from state-owned to private enterprises. For instance, an influential paper found that productivity was vastly improved when workers moved from state-owned firms, where there was little incentive to work hard, to the private sector. But after this initial boost, their productivity increases slowed down. The vast majority of state-owned enterprises were effectively privatized in the mid to late 1990s, dropping from over 10,000 million to some 300,000 by the early 2000s. So, although there is still room for structural change, including continuing urbanization where people moved from less efficient farms into more efficient urban jobs, the scope for big, one-off jumps in productivity is less now so won’t be a big source of growth in the future. Estimates show that around 8% of China’s GDP growth is driven by the shift of resources from the public sector to the private.
What about spillover gains tied to foreign direct investment, joint ventures, and other ties to developed countries? Those have undoubtedly had an impact on the Chinese economy since taking off in the mid-to-late 90s. My own research with John Van Reenen has shown that GDP growth would be lower by between 0.43 to 1% per year if not for joint ventures that allowed for transfers of knowledge and technology, as opposed to domestic innovation. Positive spillovers and imitation of existing know-how, which can be controversial if it’s done via piracy instead of paying for a license, thus could account for between one-third to two-thirds of TFP. It implies that TFP driven by innovation and technological progress (independent of foreign investment) accounts for about 5 to 14% of GDP growth.
The other big component of economic growth is how much output is raised by increasing the inputs — adding more capital or workers — what economists call factor accumulation. Multiple studies have found that China’s economic growth is largely labor-intensive with high levels of fixed capital investment. Researchers have estimated that 10 to 20% of GDP growth may be attributable to the growth of the labor force, while capital accounts for about half of growth. But it’s also essential to figure out which portion comes from skilled workers (often called human capital). In other words, growth isn’t just about adding more workers. It’s the quality of those workers that also matter — other experts have argued , for instance, that economic growth driven by improvements in education and skills has the potential to be more sustainable. Human capital accounts for between 11 to 15% of China’s growth. Factor accumulation (capital and labour) thus accounts for about 60 to 70% of GDP growth.
Summarizing the evidence, capital accumulation accounted for 3.2 percentage points of the 7.3% growth in output per worker from 1979-2004 with TFP accounting for 3.6 percentage points. Since the modern “open door” policy took off in the early 1990s, capital accumulation has accounted for 4.2 percentage points of the higher 8.5% growth in China, and interestingly outweighs the contribution of TFP (3.9 percentage points over that time frame). These estimates suggest that capital accumulation has contributed around half of China’s economic growth, which is in line with other estimates that find that most of China’s growth is accounted for mostly by capital accumulation rather than TFP growth. That means that the next stage of growth will need to focus on TFP or raising the overall productivity of the Chinese growth drivers. Getting more from workers and investments will be crucial, and perhaps one of the hardest challenges any economy faces as it seeks to become more prosperous.
To achieve its ambition of sustaining growth for another 30 years, China will require not only technological and human capital improvements, but also reform of its rule of law, the role of the state, and the re-balancing of its economy. Re-balancing the economy will involve boosting domestic demand (consumption, investment, government spending) to grow more quickly than exports, shifting toward services (including non-tradable areas) and away from agriculture, increasing urbanization to increase incomes, and permitting greater external sector liberalization, including the internationalization of the RMB .
To achieve these aims will also require examining the role of the state in China and the legal system. The retention of large state-owned enterprises and the increasingly perceived “un-level playing field” for both foreign and domestic private firms raises doubts as to the efficiency of China’s markets and thus its ability to overcome the “middle income country trap,” whereby countries start to slow after reaching upper middle income levels. For China to realize its potential as an economic superpower requires reforms of both the microeconomic drivers of productivity as well as significant transformation of the structure of its economy.