China’s declining productivity: factors behind the economic slowdown

China’s economy is facing a recession, with growth slowing from 6.5 percent before the pandemic to just 4.6 percent now, and there are concerns that even that number is seriously inflated. As the economy stagnates, the standard of living remains far below that of developed countries, further highlighting the country’s economic struggles, Asia Times reports.

A major issue contributing to this recession is a country’s declining total factor productivity (TFP), which is a measure of how efficiently inputs such as labor and capital are used to generate output. While official data points to a decline in TFP over the past decade and a half, this claim continues to be debated. Despite this, there is widespread agreement that productivity growth has slowed considerably compared to earlier years.

Economist Paul Krugman has pointed to the shift toward real estate as a major factor in the recession. Following the 2008 global financial crisis, China began pouring resources into a low-productivity industry, the real estate sector, which slowed overall productivity. Additionally, the 2022 analysis highlighted broader structural issues in China’s economy, including inefficiencies in capital allocation and an over-reliance on a growth model driven by resource extraction. These systemic challenges, which already existed before the pandemic, have been worsened by trade tensions, COVID-19 disruptions, and aggressive industrial policies implemented by the Chinese government.

In retrospect, earlier assessments of China’s economic prospects appear overly optimistic. Arthur Kroeber’s 2016 book China’s Economy: What Everyone Needs to Know® envisions China successfully transitioning from a resource-driven model to one driven by productivity and technological innovation. However, in the years since, this optimism has waned as the country struggles to maintain the productivity growth needed for sustained prosperity. Kroeber acknowledged that China faced economic challenges, but his/her hopes for a shift toward efficiency-driven growth appear low today. Despite the value of Kroeber’s insights into fiscal federalism, urbanization, and real estate, his/her optimism about China’s future no longer matches the reality of the country’s economic trajectory.

A major reason for the recession is that China is reaching the limits of its growth potential. While countries such as Japan, South Korea, and Taiwan successfully transformed into high-income economies by focusing on technological advancements and productivity, China’s growth has slowed, as have other middle-income countries such as Thailand. Since 2011, TFP in China has been declining, with some reports even showing negative growth. As China approaches the technological frontier, it becomes more challenging to acquire advanced technologies, as companies around the world protect their innovations more strictly.

China’s demographics are another factor contributing to the productivity slowdown. For years, China benefited from a “demographic dividend”, a large, young workforce with relatively few dependents. However, this advantage has begun to diminish as the country’s working age population began to decline around 2010. Studies have shown that aging populations correlate with lower productivity growth, and China is no exception. Due to low worker entry into the labor force and an aging population, the economy faces a significant challenge in maintaining productivity levels.

Urbanization, which has historically boosted China’s productivity by shifting workers from low-productivity agricultural jobs to higher-productivity urban manufacturing roles, is also losing momentum. While urbanization helped China achieve rapid economic growth for decades, experts point to the 2010s as the “Lewis turning point”, when surplus labor in agriculture began to decline. Additionally, China’s hukou system, which restricts internal migration, has further limited the benefits of urbanization. These demographic and structural changes have led to a decline in productivity growth, and the tailwinds of technology adoption, urbanization and demographic growth are no longer strong enough to keep the economy growing at the same pace.

Another important challenge facing China’s productivity is its research and development (R&D) sector. While China has increased its focus on R&D in recent years, studies have shown that state-owned enterprises (SOEs) generally show much lower R&D productivity than private or foreign-owned companies. Research by Koenig et al. (2021) suggest that although R&D investment has contributed to productivity growth, the impact has been modest due to issues such as resource misallocation and misclassification of expenses as “R&D”. Furthermore, while China has expanded its university research sector and increased its research expenditures, there are concerns about the quality of Chinese academic research and its global leadership. Plagiarism, data falsification and nepotism have been reported in the country’s scientific community, reducing the effectiveness of research and contributing to its low productivity.

China’s export market is also facing constraints, which has impacted the country’s productivity. Economic theories suggest that global competition promotes innovation, increasing productivity through “export discipline”. However, since the 2008 financial crisis, demand for Chinese goods has slowed due to trade wars and market saturation. Although exports to the EU have increased, this has not compensated for declines in other markets. Additionally, China’s exports to developing countries have increased, but the purchasing power of these countries is very low. As a result, China’s share in global exports is declining, reducing the benefits of export-led growth. This shift from an export-led model to a focus on domestic investment presents challenges for the country’s long-term productivity growth, reports Asia Times.

China’s low consumption rate also plays into its productivity challenges. Unlike the US, where consumption drives economic activity, China’s economy remains highly investment-oriented. Domestic consumption in China accounts for only 39 percent of GDP, while in the US it is more than 80 percent; as a result, companies have less incentive to innovate and differentiate their products. This low consumer demand makes it difficult for China to develop high-quality, innovative products that can drive productivity growth. Furthermore, China’s policies generally prioritize investment over consumption, which has inadvertently slowed productivity.

The country’s approach to managing economic stability has also hindered productivity. From 2008 to 2016, China used massive state-controlled bank lending, especially in the real estate sector, to prevent recession. While this strategy helped maintain economic stability, it also strengthened low-productivity industries such as real estate and state-owned enterprises. The rapid distribution of wealth during this period led to inefficient projects and increased reliance on sectors with limited productivity growth. These measures, although effective in avoiding recession, have left China’s economy overly dependent on industries with low productivity growth.

In an effort to address these challenges, President Xi Jinping has launched initiatives such as Made in China 2025, which aims to grow the domestic semiconductor industry and reduce China’s dependence on foreign technology. However, whether these strategies will successfully reverse the productivity slowdown remains uncertain. Over the past three years, Xi has taken a more aggressive approach by targeting adversarial industries such as consumer internet, finance, video games, entertainment and real estate. his/her efforts are aimed at redirecting resources – such as talent and capital – toward industries he/she views as more aligned with China’s long-term economic goals.

Xi’s strategy departs from traditional industrial policies, which typically focus on supporting successful sectors. Instead, he/she is attempting to destroy industries he/she deems detrimental to the country’s future. For example, companies like Alibaba, Tencent and Baidu, once seen as the backbone of China’s innovation, are now under scrutiny, Asia Times reported.

This change has raised concerns about the impact of such policies on entrepreneurship. If the government may suddenly change its priorities or seize successful companies, creating an environment of uncertainty and risk, entrepreneurs may be reluctant to start new ventures. Although shifting resources toward preferred sectors may initially be successful in redirecting talent, the long-term effects on innovation and entrepreneurship remain unclear.

China’s efforts to overcome its productivity challenges face significant obstacles. While the government continues to implement policies aimed at boosting certain sectors, broader structural issues still persist, including demographic change, inefficiencies in R&D, and declining export demand. Whether Xi Jinping’s industrial policies can effectively address these challenges and restore China’s productivity growth remains an open question, with many experts concerned about the country’s ability to break free from its current economic stagnation. Have expressed doubts.