China’s economy is slowing. The downturn may be the result of recent events -- the trade war with the US, or retrenchment in China’s real estate and infrastructure sectors. But it may also be the latest manifestation of a trend that began a decade ago. And it may signal that China’s entire system of authoritarian state capitalism is less effective than many had believed.
Recent data suggest that consumption is falling, indicating rocky times ahead:
But China’s woes go far beyond the current business cycle. After the financial crisis, China’s total factor productivity growth -- a measure of how fast an economy increases the efficiency with which it uses labor and capital -- suddenly began to fall, and has stayed low ever since.
When total factor productivity growth slows, a country can only grow by increasing its supply of labor and capital. With China’s working-age population in steady decline, and its supply of cheap rural labor exhausted, workforce expansion isn’t available. That leaves capital. Since the Great Recession hit, China has poured resources into physical investment, primarily in real estate and infrastructure.
More physical capital means more wealth -- more apartments to live in, more roads to drive on, more trains and roads connecting cities and neighborhoods with each other so that commerce can flourish. These all represent real increases in national wealth. But without productivity gains, this capital-intensive strategy eventually runs into diminishing returns.
More ominously, there’s mounting evidence that China’s shift to a construction-based growth model has acted to slow productivity growth, by diverting resources and investment into inefficient industries and companies.
When the financial crisis hit in 2008, China responded by increasing lending. The country’s big banks are all state-owned, and they lend when the government tells them to. In addition, the government uses several kinds of credit policy, especially reserve requirements, to control the activities of the banking system. Starting in about 2012, lending shifted from big banks to shadow banks, especially so-called wealth management products and entrusted loans -- lending vehicles set up to offer savers high returns, but also more susceptible to collapse than conventional banks. Thanks to these shadow banks, the lending-based stimulus of 2008-2010 has essentially continued forever.
Where did all the money go? When the government suddenly tells banks and shadow banks to lend money, they don’t have time to hunt around for the innovative companies creating next-generation technologies or venturing into high-value-added export markets. Instead, they send the money to familiar borrowers always hungry for financial capital -- local governments, state-owned enterprises, real-estate projects and infrastructure.
These sectors can produce a lot of economic growth, fast. Concrete gets poured, steel gets rolled, coal gets burned. But these are not really activities that teach people how to do new things -- instead, it’s more of the same. A 2016 paper by economists Lin William Cong, Haoyu Gao, Jacopo Ponticelli and Xiaoguang Yang found that China’s stimulus “disproportionately favored state-owned firms and firms with lower average product of capital.”
This change might amount to a permanent shift in China’s entire growth model. A 2016 paper by economists Chong-En Bai, Chang-Tai Hsieh, and Zheng Michael Song argues that the stimulus of 2008-2010 created a permanent increase in local governments’ ability to obtain easy money from the financial system. The unparalleled stability afforded by China’s debt-fueled macroeconomic stimulus policies may have come at a steep cost in terms of long-term productivity growth.
In other words, although many outside the country still think of China as dependent on exports and focused on becoming the workshop of the world, that period in its history may now be over. Instead, China may have shifted to a model of capital-intensive growth based on domestic demand, easy financing, and large construction projects by state-owned and locally well-connected companies. And that, in turn -- as Bai et al. suggest -- may be a big reason for the productivity slowdown.
That should worry China’s leaders. As writer Joe Studwell chronicles in his book “How Asia Works,” East Asian economies like those of Taiwan and South Korea have managed to reach rich country levels in large part by relentlessly pushing into global markets dominated by high-value goods. In the early and mid-2000s it looked as if China was following the same path. But the stimulus that ensured economic stability in the midst of global turmoil may have bumped it off of the escalator to prosperity. The country now faces the disturbing specter of being stuck in the so-called middle-income trap.
China’s leaders are obviously aware of the danger on some level. The Made in China 2025 initiative is clearly an effort to get the country back on the export-led track to fast productivity growth. But with the developed world growing increasingly cold toward the prospect of Chinese high-tech exports and investment, geopolitics may stymie this move before it can get off the ground.
Ultimately, China’s productivity woes may simply represent the natural limitations of an authoritarian system of governance. The power wielded by China’s state-owned enterprises, state-owned banks and cash-hungry local governments is diverting money from more productive enterprises. The lack of regular elections probably makes China’s leaders more desperate for economic stability (since a recession could spark a revolution), making them willing to sacrifice long-term growth for gains today. And China’s aggressive espionage efforts and threatening military posture have prompted its trading partners to close the door to its most promising growth industries.
For years, many wondered when or if China’s economic interventions would cause its growth to slow; we now may have an answer.
Noah Smith is a Bloomberg Opinion columnist. -- Ed.