HH China’s Economy Needs Institutional Reform Rather Than Additional Capital Deepening

In June 2020, a group of six World Bank economists issued a very interesting paper called “China’s Productivity Slowdown and Future Growth Potential,” in which they explain why Chinese productivity growth has declined so markedly over the last several years. The authors argue that China’s total factor productivity (TFP) growth was between 3.1 percent and 3.5 percent in the 1980s and 1990s, after which it began to drop. They go on to say:

Aggregate TFP growth slowed from 2.8 percent in the 10 years before the global financial crisis to 0.7 percent in 2009–18. In 2017, signs of improving labor productivity and TFP growth emerged but both remain significantly lower than their pre-crisis levels. Although weaker productivity growth in China has coincided with—and likely been affected by—the recent decline in world productivity growth, the deceleration in China has been sharper.

The paper provides some very helpful details about China’s declining productivity growth, including differences by time period and by region, and it also suggests how sector shifts may have affected changes in productivity. Among other things, the paper recommends policies to hasten the shift in the Chinese economy away from less productive sectors; it argues, correctly in my opinion, that “strengthening market institutions for the effective management of insolvency, firm restructuring, and bankruptcy could accelerate productivity growth.”

These recommendations are almost certainly good ones, if a little generic (an occupational hazard of World Bank papers), and the paper is well worth reading for those interested in understanding problems in the Chinese economy. But I have two big “systemic” problems with the approach taken in this paper—and in many, if not most, similar China-related academic papers. My criticism isn’t really specific to this paper, in other words, but a response to an overall approach that seems to dominate academic analysis of the Chinese economy.

These World Bank authors assume that China’s total levels of economic and productivity growth will continue creeping closer and closer to those of the West as long as the country continues to attract capital and secure technology transfers. But there are compelling reasons to believe that such steps won’t be nearly enough to get China’s economy on par with the West in per capita terms.

THE PERILS OF MEASURING CHINA’S GDP (AND PRODUCTIVITY)

My first problem is in measuring productivity growth. The authors use a standard Cobb-Douglas production function—in which output is a function of capital, labor, and TFP—to decompose the components of output per worker. This, of course, requires a measure of output, for which the authors use the real GDP data provided by China’s National Bureau of Statistics. GDP data is the standard measure of economic output that economists use for most countries, so this is a pretty common approach to measuring productivity. But, of course, it implicitly assumes that GDP growth in China is as much a proxy for real value-creation in the economy as it is in any other country.

Here is where the problem lies. Most economists agree that China suffers substantially more from nonproductive investment than other countries do, and because this investment is not written down to the extent that bad investment is recorded in other countries, it should follow that China’s GDP data is not comparable to that of other countries. Put differently, while GDP growth in China is a measure of the growth in economic activity, as it is in most economies, the relationship between economic activity and value creation is not the same in China as it is in most other countries. That means that GDP growth cannot be used in the same way as a meaningful measure of output with respect to China.

Notice I am not just saying that GDP isn’t a perfect measure of value creation in China. It isn’t a perfect measure anywhere in the world, but as long as it has some consistent and unbiased relationship to output, GDP growth rates can nonetheless be useful in comparing the evolution of a country’s “real” economy over time and in comparing the performance of various economies.

The problem in China is a very different one. The fact that a large and rising share of economic activity in the country consists of nonproductive investment that isn’t correctly written down means two things. First, the relationship between Chinese GDP growth and growth in the real economy isn’t consistent. Second, Chinese GDP growth is not comparable with that of other countries. Those with an accounting background would say that what in other countries would be expensed is in fact capitalized in China: this approach necessarily must result in faster growth and higher asset values on paper in China compared to the underlying value of the economic activities themselves. More specifically, GDP growth in China will overstate the relative growth in output for many years, until, basically, the country reaches its debt constraints, after which GDP growth will be understated mainly because the same amount of “real” growth will be measured against an artificially high base.

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