This Is Chinas Real Economic Problem

China bulls could be forgiven for some self-­congratulatory back-patting these days. The country’s gross domestic product expanded 6.9 percent in the first three months of the year, the fastest rate since the third quarter of 2015. China is showing “marked improvement in economic performance, and major economic indicators have continued to move in a positive direction,” Premier Li Keqiang told global business leaders at a World Economic Forum meeting in Dalian on June 27.

But one key indicator—total factor productivity—gives a more worrisome picture of China’s economic health. Total factor productivity is the extra output that the economy produces without additional labor or capital—it’s what creates prosperity. While productivity in the manufacturing industry grew an average of 2.6 percent a year from 1998 to 2007, growth has been almost zero since, according to Loren Brandt, a China specialist at the University of Toronto. In the U.S., by contrast, productivity growth fell from 1 percent to about 0.5 percent over the same period, he says.

It isn’t unusual for productivity to slow once the easy gains that come from industrialization, the development of supply chains, and the embrace of technologies such as computers are used up. “You would expect productivity to come down, but not as sharply as we’re seeing” in China, Brandt says.

So what explains the dramatic drop? There’s a pretty obvious culprit. To combat the effects of the global financial crisis, China unleashed a 4 ­trillion-yuan ($586 billion) stimulus program in 2008, much of it directed at state-owned enterprises (SOEs), to prop up growth and avoid mass layoffs. While the spending helped China avoid a deep slump, the focus on SOEs hurt the private sector. Today, state companies get almost 30 percent of all loans but contribute less than a tenth of GDP, according to Gavekal Dragonomics, a Beijing-based economic consulting firm. “The government’s repeated use of state-owned enterprises to stimulate short-term activity has weakened the private sector and lowered productivity growth,” Andrew Batson, research director at Dragonomics, wrote in a May report. As a result, China is “increasingly locked into a slower-growth future.”

In most economies, market competition helps drive productivity gains. But China’s long love affair with industrial policy has only intensified under President Xi Jinping, as demonstrated by the launch two years ago of Made in China 2025, a blueprint for a comprehensive industrial upgrade that complements the 13th Five-Year Plan. The goal is to foster national champions in fields such as aerospace, robotics, and new energy vehicles through a combination of easy credit, subsidies, tax breaks, and other perks. In the process, Beijing and local governments are extending the life of some corporate zombies, which prevents healthier businesses from taking their place. “In dynamic economies, we expect that the really good firms are going to be more productive, be more profitable, and so they will capture more and more market share,” Brandt says. “When bad firms are forced to exit, that is an important driver of productivity. In China, that is almost not happening at all.”

China offers tax breaks to companies that invest in research and development, while some local governments, including Guangdong’s, also provide subsidies for each robot a company purchases. SOEs are better positioned to take advantage of such largesse because of their ties to Communist Party cadres: So while 75 percent of SOEs spend money on R&D and 14 percent have robots, the comparable figures for private companies are 42 percent and 6 percent, according to a survey of 1,200 businesses by Wuhan University, Stanford, the Chinese Academy of Social Sciences, and the Hong Kong University of Science and Technology.

That private-sector businesses skimp on such productivity enhancements is a particular concern given the country’s rising wages. Over the past decade, the average monthly manufacturing wage has more than doubled, to 4,126 yuan ($607), higher than in Mexico and Malaysia, according to the joint study, which was published last month. Productivity is failing to keep pace with rising wages, which is “putting great pressure on the profits of countless Chinese firms,” says the report.

So what’s to be done? Brandt says the impressive productivity gains China realized before 2008 resulted from a series of market-opening reforms, including the shuttering of tens of thousands of state enterprises starting in the late 1990s and the lowering of import tariffs and other barriers to ­competition—a condition for the country’s entry into the World Trade Organization in 2001. The problem is that the ­market-liberalization push has pretty much stalled, he says. Xi should open protected sectors of the economy, such as telecommunications and freight hauling, to competition and allow more zombie companies to die. “There is a lot of misallocation of resources and inefficiency in the Chinese economy,” Brandt says. “If they eliminate that, there’s still the potential for huge productivity gains.”

    BOTTOM LINE – Productivity in Chinas manufacturing industry grew, on average, 2.6 percent a year from 1998 to 2007 but has since flatlined.

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