“Establishing a unified, open, competitive and orderly market system is the basis for the market to play a decisive role in the allocation of resources.” Communiqué, Third Plenary Session of the 18th Central Committee of the Communist Party of China, November 12, 2013.
“The fundamental obstacle to implementing far-reaching economic reforms in China is the top leadership’s view that, while state-owned firms may be a drag on China’s economic growth, they are essential to maintaining the position and control of the Chinese Communist Party and achieving the party’s strategic objectives.” Nicholas Lardy, The State Strikes Back: The End of Economic Reform in China?, Peterson Institute for International Economics, January 2019.
China is now a top-rank, market-moving source of daily news. It is not only the world’s second largest economy, but over the past decade, it accounted for nearly thirty percent of global economic growth. No wonder stories about a slowdown in China and trade conflict with the United States send shudders through financial markets. As conditions are worsening, uncertainty has jumped to record levels in China and elsewhere (see chart).
Economic Policy Uncertainty Index, 1995-2018
In the near term, if China and U.S. trade negotiators can come to an agreement avoiding a further hike of U.S. tariffs, some of this heightened uncertainty may fade. But a more persistent source of risk arises from China’s medium- and long-term growth prospects. While the country has sustained 6%-plus growth since 1991, in recent years it has done so by increasing investment per unit of growth. The prominence of these diminishing returns from incremental capital outlays leads many informed observers to conclude that a further medium-term deceleration is inevitable. Worries about the sharp increase in nonfinancial corporate debt over the past decade, and the lack of transparency regarding the risks in China’s financial system, only serve to compound this pessimism.
Given these circumstances, Nicholas Lardy’s excellent new book, The State Strikes Back, could hardly arrive at a better moment. Using careful analysis to challenge common hypotheses, Dr. Lardy takes a close look at the principal factors affecting China’s longer-run growth prospects. Ultimately, he is hopeful, but realistic: China could sustain its recent pace of growth for an extended period—or grow even faster—but only if the government is willing to return to its earlier commitment to serious reforms that favor market, rather than state, allocation of resources. So far, despite the prominent market advocacy in its 2013 “policy blueprint”—the first under President Xi Jinping’s leadership (see the opening citation)—the Xi government has shifted in precisely the opposite direction.
In the remainder of this post, we explore Lardy’s conclusion that China’s growth potential remains high. On the key issues of substance, his logic is compelling. A combination of the opportunities generated by convergence to advanced-economy productivity levels, continued improvements in competition and trade, and a renewed shift toward the private allocation of resources—especially through changes in the structure of both state-owned enterprises and the financial system—points to the possibility of a return to higher growth. Nevertheless, we find ourselves somewhat less hopeful. Even if China’s government were to make fundamental economic reform its top priority, in our view the odds favor a further slowdown over the next decade.
Let’s start by recalling Lardy’s previous book, Markets Over Mao: The Rise of Private Business in China. Published in 2014, that work highlights the critical role of private business in driving China’s unprecedented expansion. Over the 35 years beginning in 1980, the Chinese economy grew more than 25-fold, increasing its share of global activity from roughly 2 to 17 percent, and elevating living standards from one of the world’s poorest economies to the “upper middle income” category. Markets Over Mao emphasizes the transition to market (and away from administered) prices in allocating resources. Lardy goes on to identify private firms as the driving force behind China’s massive shift from autarky to its place as the world’s top trading nation.
That earlier book anticipates a continuation of the shift to markets—in line with the opening citation—under President Xi. But the facts have changed, and along with them so has Lardy’s assessment. Marshalling a wide range of evidence, The State Strikes Back highlights the willingness of the current regime to sacrifice efficiency and growth to sustain a large role of the state, and particularly to ensure a continuing role for state-owned enterprises.
If China were to return to the path it was on just a few years ago, increasing its reliance on the market allocation of resources, the result might be a continuation of the rapid convergence to the output levels of the advanced economies. What would such a path look like? According to the Maddison Project Database, the ratio of China’s per capita real GDP to that of the United States soared from 5.0% in 1977—the year before China’s economic reforms began—to 23.2% in 2016 (the latest observation). As Lardy highlights, several rapidly-growing Asian economies that previously reached this ratio of per capita real GDP (on the way up) continued to experience rapid growth in the succeeding 20 years (see chart).
Average annual growth rates of per capita real GDP (bars, left) and per capita real GDP (percent of U.S. level, right)
Could China follow the paths of Japan, Korea, Taiwan and Singapore, growing between 5 and 7 percent annually through 2040? We don’t want to rule anything out, but China is different in some very important ways. First, it is far larger than all of them combined and already accounts for nearly one-fourth of global merchandise trade. Second, the external environment is different: the global economy is expanding more slowly than when these Asian economies experienced rapid growth. Combined with rising protectionism and security-related concerns, these factors severely limit China’s potential for export-led growth.
However, the enormous scale and diversity of China’s domestic economy present growth opportunities that other nations do not share. Consider, for example, the extraordinary productivity differentials that remain among firms within industries and across regions: where market forces dominate, creative destruction should promote convergence to best practices and higher productivity (see, for example, Hsieh and Klenow). Similarly, continued urbanization (see here and here) should help sustain productivity gains: China’s urban population share (58% in 2017; up from 18% in 1977) continues to rise rapidly, but remains far below that of Brazil (86%), the European Union (75%), Russia (74%), or the United States (82%).
As Lardy points out, obstacles created by China’s government are impeding these growth opportunities. At the top of the list is the support for less productive state-owned enterprises (SOEs), including both the continued supply of cheap credit and the imposition of barriers to entry.
Lardy presents an array of evidence that SOEs remain less productive than private firms. Perhaps the most striking is the gap between the return on assets (ROA) of the two groups: after narrowing during the period prior to China’s 2001 entry into the World Trade Organization, following the 2007-09 crisis, the gap expanded sharply and remained wide (see chart). Following a careful review, Lardy concludes that it is not possible to explain the widening gap or the sustained decline in SOEs’ ROA since 2007 with a set of standard factors (including differences in the cost of capital, the product mix, and the social burdens absorbed). Reported losses (understated by including state subsidies as revenues) further highlight weak and declining SOE performance in the past decade: as a share of GDP, SOE losses doubled to 2.6% in 2016 from 1.3% in 2005 (see Lardy Table 2.1). Despite producing only one-fifth of the output, among industrial firms, SOEs account for nearly three-fifths of total losses in 2016.
China: return on assets by type of firm, 1997-2017
Lardy goes on to highlight an extraordinary shift of resources to poorly performing SOEs. After plunging from 2006 to 2011, and despite the low ROA and large losses just mentioned, the state share of total investment bottomed out and began rising again in 2016. This ability to expand investment in the face of poor performance reflects the continued privileged access that SOEs have to bank funding. Indeed, after 2013, the share of bank loans flowing to SOEs surged (see chart). Part of the shift probably reflects the willingness of private firms to obtain market-priced funds from “shadow banks.” However, in an effort to contain the national credit boom, policymakers began to squeeze that source sharply in recent years. While slowing overall credit expansion was necessary, limiting shadow banking has reduced funding to private borrowers without decreasing the high leverage of SOEs (or pushing the zombies among them out of business once and for all).
Share of bank lending to firms by type, 2010-16
In light of this overwhelming evidence, Lardy’s prescriptions for promoting growth in China focus on the need to level the playing field between SOEs and private firms. That would require China’s banks—including those influenced by local governments—to impose hard budget constraints on firms with persistent losses. Among other things, it would mean greater accounting transparency, allowing lenders and investors to distinguish between firms with viable business models capable of growth and those without them. And, the government would need to ease the entry barriers—especially in services where obstacles remain high—that protect SOEs from private competitors, both domestic and foreign.
Perhaps the Xi regime will oblige. But the historical record is not encouraging. As Lardy also highlights, recent SOE reform efforts were limited, especially compared to the large reforms of the 1990s. Some approaches, like corporatization and mixed ownership, have run their course; while others, such as debt-to-equity swaps, have been used only sparingly. Then, there are the concerns of private investors regarding the protection of property rights: even the leaders of private firms—especially the large ones—may need state support to succeed (see Milhaupt and Zheng and Economy, pages 211-12). Finally, Naughton highlights the “impossible trinity” of goals that render recent SOE reforms ineffective: “improvements in SOE incentives and governance, strengthened oversight and greater responsiveness to politically defined targets.”
Even if the Chinese government were to reverse course—say, in response to the ongoing trade disputes—and reorient the economy toward market-based resource allocation, allowing SOEs to shrink (and even wither), we are less hopeful than Lardy about elevating the rate of growth in China from recent levels on a sustained basis. Pritchett and Summers emphasize that long-run economic growth is characterized by regression to the mean, reflecting a lack of persistence in growth rates (both high and low) that makes the long-run trend very difficult to forecast. Based on a cross-country sample of historical growth rates and current per capita income, their forward-looking China scenario is for 20-year average annual growth of 3.9%. Indeed, for the 33 countries in the 169-country Maddison sample that crossed the 25% ratio of annual per capita GDP growth (on the way up), per capita GDP growth over the next 20 years averaged 3.7%—virtually identical to the Pritchett-Summers norm.
Against this background, sustained rapid convergence at the pace Japan, Korea, Singapore, and Taiwan experienced remains a hopeful outlier—possible, but not likely. Since 1950, only seven other economies—Chile (1993-2013), Greece (1958-78), Hong Kong (1956-76), Israel (1953-73), Italy (1951-71), Libya (1956-76), and Trinidad (1990-2010)—exhibit average annual per capita GDP growth of at least 5 percent for the 20 years after crossing the 25% threshold. Importantly, all of these rapid-growth episodes occurred in a less troubled global environment and, aside from Italy (where the gains partly reflected postwar recovery), all were small economies that could benefit from extended periods of export-led growth.
Our bottom line: as Lardy suggests, in the absence of an extraordinary course reversal in government policies, as the role of the state impinges on private dynamism, growth in China will likely slow substantially over the medium term. Even with a major policy shift that provides greater scope for (domestic and foreign) private activity, a substantial pickup in growth would surprise us more than a continued decline.