A Lethargic Dragon
From the May 14, 2012, issue of NR.

Communist Party leader Bo Xilai


Reihan Salam

After 1989, however, the Chinese government embraced a different approach. Rather than tolerate the rise of homegrown private entrepreneurs, Beijing decided to channel investment toward coastal regions and large state-owned enterprises. The financial reforms of the 1980s were largely reversed, as were the political reforms. The result has been a form of investment-led growth that has enriched China’s exporters and its political elites at the expense of Chinese workers.

So why is investment-led growth a problem? It’s not — or at least not intrinsically. Much depends on how efficiently investments are used to increase economic output. Economic expansion flows from two sources: increases in inputs, such as growth in employment levels, rising skill levels of workers, and a greater stock of physical capital; and increases in productivity. Increases in inputs alone can go a long way, particularly in a country that starts out very poor.

China has seen an extraordinary increase in inputs. High domestic savings rates allowed for massive investments in the stock of physical capital. A growing share of the population has been of working age, increasing the size of the labor force. And the shift of workers from low-productivity agriculture to high-productivity manufacturing has been a huge boon.

But these drivers have all but run their course. Higher domestic savings rates have come at the expense of lower consumption levels, and a resentful Chinese population increasingly wants to spend what it earns. Even more important, capital has been misallocated on an extraordinary scale, owing to tight political control of the financial system. China’s population is aging rapidly, and soon the country will have to carry the weight of tens and eventually hundreds of millions of retirees. Despite the Chongqing experiment, the scope for shifting more agricultural workers into manufacturing is limited, not least because China’s cost advantage is eroding and a weak global economy can absorb only so many of the country’s wares. China’s growth is already slowing as a result. Since 2001, China has grown at an annual rate of 10.1 percent. This year, however, Chinese GDP is expected to grow at 7.5 percent. Further, the official statistics almost certainly conceal the extent of the decline. Scholars such as Huang have found inconsistencies between local and national data, and curious patterns such as rapid GDP growth during periods in which electricity usage, a good hard indicator of economic activity, experienced a sharp slowdown.

What China needs now is not to ramp up inputs even further, but rather to ensure that capital is allocated efficiently. Growth in the advanced market democracies has been driven primarily by productivity-enhancing technological innovation, which refers not just to the invention of new machines but also to the embrace of new ways of combining technology and labor. The advent of new communications technologies is one thing. Walmart’s ingenious use of these technologies to make its employees more productive is quite another.

But this kind of productivity-enhancing technological innovation is far less likely to occur if capital is allocated according to political criteria rather than by investors and entrepreneurs in an open market. For years, Michael Pettis, a professor at Peking University’s Guanghua School of Management, has been arguing that the Chinese economy has been badly undermined by this kind of politicized capital misallocation. As he put it in his newsletter last year, “investment in high-prestige areas such as electric cars, solar panels, and so on for technologically backward countries with low worker productivity may be a little like investment in the space program or in the Olympics.” While these efforts might give a boost to national pride, “they reduce overall wealth and exacerbate domestic imbalances.” Pettis’s predictions are looking sound as the Chinese growth engine sputters.