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.