How China can achieve high economic growth for another decade

The key to reviving economic prospects lies in addressing the paradox that China is a highly distorted economy yet with substantial growth potential
Growth can no longer come from traditional drivers such as exports or property development. Rather, it requires a restructuring of the state’s role in allocating resources

Yukon Huang

Published: 9:15am, 31 Oct 2022

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China’s 20th party congress will be remembered for confirming an unprecedented third term for Xi Jinping and packing the Standing Committee with his loyalists. Xi’s report to the congress covered all the traditional themes but the emphasis was on dealing with security in its varied aspects and accelerating technological progress.

But, despite a well-choreographed show of confidence, Beijing’s entreaties could not dispel widespread concerns about China’s growth prospects. The original target for this year of 5.5 per cent seemed reasonable, considering last year’s 8.1 per cent outcome.

But shrinking Western demand for China’s exports cannot be offset by accelerating infrastructure spending, given the weak financial position of local governments. Moreover, the collapse of China’s property market along with its zero-Covid policy mean that gross domestic product growth is expected to drop to around 3 per cent for this year, despite the recently announced third-quarter growth rate of 3.9 per cent.

Economists have offered a range of solutions, with many citing the need to promote consumption. Cyclical declines in consumption can benefit from stepped-up social programmes, but sustained economic growth depends on investment and productivity increases from efficiency improvements and technological progress.

Consumption does not drive growth, it is the other way around – increased consumption comes from more rapid growth. Given China’s already high investment levels, the challenge is to boost the productivity of investment, which has been declining steadily for nearly a decade.

Tech-oriented commentators point to innovation as the key to promoting growth and security. There is a strong correlation between a country’s innovation capacity and its per capita income. The richer a country, the greater its innovative capacity.

But the reverse is not necessarily true, namely that the harder a country tries to innovate, the faster it will grow. China stands out in trying to “leapfrog” ahead in becoming more technologically advanced than would be expected for its income level.

A notable precedent is South Korea, which dramatically increased its research and development efforts, and succeeded in becoming more technologically advanced – comparable to Japan, but at a much lower per capita income level.

But less well recognised is that South Korea’s growth rate was cut nearly in half in the process, to 2.8 per cent annually over the past decade (2012-21) from 5.3 per cent over the previous two decades (1992-2011). The same is likely to be true for China as resources are diverted into more speculative hi-tech activities from alternative higher-return investments.

The financial community has focused on resolving the problems afflicting the property market, as exemplified by the collapse of Evergrande and households curtailing their mortgage payments for unfinished flats. The past practice of developers drawing on the upfront payments of buyers to finance land purchases worked well as long as demand remained strong, but this system is now untenable.

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A major restructuring of financing practices is needed. But these actions will still not solve the double-edged problem that housing demand has moderated because the pace of urbanisation has slowed and “hukou” residency restrictions have distorted the spatial pattern of urbanisation.

The key to reviving China’s growth prospects lies in addressing the paradox that China is still a highly distorted economy, yet it still has substantial growth potential. Future growth cannot come from traditional drivers such as exports or property development. It requires the restructuring of the role of the state in allocating resources.

What are these major distortions? The most glaring is the impact of China’s unique hukou restrictions which prevent migrant families from settling in preferred mega cities like Shanghai or Beijing. The result is that China’s largest cities are both too small and not dense enough, while its medium-sized cities are too large because it is easier to secure residency rights in smaller cities.

As noted in the World Bank’s Urban China Report, the consequence is that the productivity of labour in the largest cities is much greater than in the smaller cities. Thus, simply allowing households to live where the more productive jobs are would significantly increase GDP growth.

Xi’s common prosperity initiative, including the push to eliminate absolute poverty, has resulted in channelling more public investment to the poorer inner provinces, especially the far west, over the past several decades.

The problem is that the rates of return in these provinces are much lower than for investments in the more commercial coastal and central provinces. A more balanced regional approach in favouring investments with higher productivity is needed to realise more rapid growth.

The wide gap between returns on the assets of state-owned enterprises (SOEs) and private companies is indicative of the misallocation of resources in China’s socialist system. An unwillingness to address the sacrosanct principle of state ownership in strategic activities has prevented any meaningful reform.

But in recent years, the emergence of so-called hybrid firms, as highlighted by the research firm Gavekal, comprising SOEs with significant private participation, suggests that performance can be improved without challenging ideological principles.

Taken together, such reforms would lead to growth of 5-6 per cent annually for another decade instead of the 3-4 per cent that many forecast. With a third term, Xi now has the authority to tackle these politically sensitive structural reforms.

While his report to the party congress highlights the need for a strong economy, the focus is more about strengthening security – political security in dealing with US-China tensions, technological security in becoming more self-sufficient in semiconductors, and health security through zero-Covid practices.

Yet, a more rapid growth path is a prerequisite if China is to become a more secure nation. Will China’s leadership address this challenge?

Yukon Huang is a senior fellow at the Carnegie Endowment for International Peace and author of “Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong”