China must set free its smaller businesses to create jobs

Premier Li Keqiang recently cited job creation as vital to China's "ultimate goal of stability in growth". His observation could not be more accurate. In fact, one of the most baffling features of China's economic rise is that, even amid double-digit gross domestic product growth, employment grew at a measly average 1.8 per cent every year from 1978 to 2004. Households, it seems, have largely missed out on the benefits of economic development in China.

The superficial explanation attributes the gap to the restructuring of inefficient state-owned enterprises, which caused public-sector employment to plummet. But there is a more fundamental cause: China's bias towards industrialisation.

China's government has long viewed industrialisation as the key to modernisation. It promotes industrial and infrastructure projects that, by encouraging investment and generating tax revenues, enable the economy to meet ambitious growth targets.

The problem is that the manufacturing sector does little to create jobs, largely because relatively high productivity growth in the sector constrains demand for more workers. By contrast, China's services sector is a much more effective engine of job creation.

In fact, services are responsible for the lion's share of employment in most advanced economies. But, whereas 80 per cent of the US labour force was employed in service industries in 2012, only 36 per cent of China's workers worked in the sector. To bolster employment in services, China's government must loosen its regulatory grip, ease barriers to entry in branches like telecommunications, and encourage labour mobility.

China's focus on industrial production is problematic in another respect: it is extremely capital intensive. At the same time, the government's interventions have limited the growth of private-sector firms by impeding their access to finance, though private firms have been responsible for most of China's job creation in recent decades.