China’s economic prospects have long elicited polarizing opinions. For those who subscribe to the “Japan-like stagnation” scenario for China’s future, the recent decline in its economic productivity tends to reinforce that view. According to the World Bank’s estimate, China’s productivity growth has dropped from 2.8% between 1999-2008 to 0.7% in the past decade.
Add that to the existing headwinds of a rapidly aging labor force and recent constraints on adopting foreign technology, are we looking at China’s secular stagnation in productivity?
The short answer to that question is no, there isn’t yet cause for alarm over China’s long-term productivity growth. However, the recent sharp decline in productivity growth is a serious problem that reflects underlying ailments of the Chinese economy. If left untreated, they will become major drags on China’s economic performance in coming years.
Productivity basically depends on how labor and capital, the two key inputs to growth, are deployed and used. In China’s case, recent productivity trends owe much more to the capital part than to the labor component. That is, investment is the main culprit behind China’s productivity slowdown.
Here I undertake a more granular examination of how investment has affected productivity growth—namely, where money is being spent and regional differentiations in investment. The bottom line is that China has invested too much in the wrong things and in the wrong places.
If this diagnosis is correct, then there is actually a silver lining: corrective actions can be taken to reverse productivity trends.
Too Much Investment in Construction
Everyone knows that China likes to build things. But what and how much it builds matters. It’s the excessive investment in construction, which accounts for the majority of China’s high level of investment, that has had the most dramatic effect on slowing productivity. To appreciate the magnitude of China’s investment in construction, let’s compare it to other East Asian economies (see Figure 1).
Figure 1. China’s Construction Investment Dwarfs Other East Asian Economies (% of GDP)
Source: Wind and MacroPolo.
China currently spends an unprecedented 25% of its GDP on construction investment, which none of the East Asian powerhouses reached even during their peak construction investment in the mid-1990s. For instance, during their construction booms, South Korea and Taiwan spending on investment were respectively 25% and 45% less as a share of GDP than China’s today.
Although China’s construction investment dipped a bit in the mid-2000s, it has kept on rising since the 2008 global financial crisis. What’s more, the Chinese government’s sizable role in construction investment creates distortions like soft-budget constraints that further erode the usefulness of these investments. Therefore, it is no coincidence that China’s construction boom of the last decade has corresponded with the sharp decline in its productivity growth over the same period.
Too Much Investment in Low-Growth Regions
Another contributor to low productivity growth is the fact that investment has disproportionately poured into poor performing regions. Twelve low-growth regions—defined as those with growth rates averaging one percentage point below the national growth rate over the last decade—that account for just a quarter of China’s GDP saw 30% of total investment in 2017 (see Figure 2). This unbalanced investment in low-growth regions naturally leads to slower productivity growth.
Figure 2. Low-Growth Regions Punching Above Their Weight in Investment (% of total investment)
Note: These 12 regions account for only a quarter of national GDP and have been growing slower, so their investment share should be around 20% of total investment.
Source: Wind and MacroPolo.
Will Productivity Rebound in China?
Given the centrality of investment in China’s productivity performance, there are basically two ways to raise productivity: reduce total investment by shifting the current growth model or allocate capital better.
The first solution is difficult to achieve and will take significant reforms, considering investment as a share of GDP has remained stubbornly constant at around 45% over the last few years. That leaves the second-best solution of addressing capital allocation, and in this area there is hope for improvement.
Regional distribution of investment will likely become more rationalized—that is, capital will flow out of low-growth regions and toward high-growth regions—as Beijing becomes less keen on subsidizing regional development and as labor mobility increases.
Indeed, a decade of trying to narrow regional income disparity through stimulating investment has yielded less-than-stellar results. Recognizing the futility of relying on investment to achieve regional economic convergence, Beijing appears to have made a significant pivot in its approach. It now aims to focus on equalizing public services rather than equalizing incomes. At the same time, the ongoing efforts to contain local government debt, which has long financed investment, will further reduce investment in low-growth regions.
Although high-growth regions have already attracted sizable investment, their potential has not been fully realized. That’s because population flows into high-growth regions have been limited as a result of the hukou policy. Over the last decade, there has been almost no net population inflow into high-growth regions. As these constraints on labor mobility are likely to be relaxed or even removed, population flows into high-growth regions are likely to pick up, which in turn will drive more investment to accommodate.
As for reducing excessive investment in construction, Beijing’s prioritization of new infrastructure (e.g. 5G, data centers, and internet of things) holds some promise. Although it is still investment in infrastructure and requires construction, in contrast to roads, bridges, and buildings, this type of digital infrastructure primarily involves investment in high-tech products and equipment.
Moreover, digital infrastructure is intended to support the growth of the digital economy, a key engine of future productivity growth. This type of investment in new infrastructure should also have spillover effects that can stimulate the growth of high-tech manufacturing like semiconductors, which will also contribute to productivity growth.
Taken together, these trends could reallocate at least a quarter of China’s total investment in coming years, likely providing a modest jolt to China’s productivity growth.