China’s economy is undergoing a profound structural slowdown

policies of the government led by Xi Jinping has naturally attracted international attention. The long sequence of lockdowns in almost three years of the pandemic has also disrupted economic activity in many important production hubs in the country.

The International Monetary Fund expects the Chinese economy to grow by a modest 3.2% this year, or 1.2 percentage points slower than its emerging markets peers in Asia. This underperformance is in stark contrast to its story in recent decades, when China went through a spectacular economic transformation that pulled hundreds of millions of its citizens out of extreme poverty. The implicit social contract between Chinese citizens and the Communist Party was that the latter would deliver rapid growth in living standards in return for which people would accept a political system that gave them only minimal freedoms.

That social contract could be weakening as China’s economy stutters. It is not just a matter of temporary lockdowns. The Chinese economy is in the midst of a broader structural slowdown because of trends in the three standard components of economic growth—labour, capital and productivity. The Chinese labour force has begun to decline. The investment boom fuelled by cheap bank credit has led to massive misallocation of capital, especially in the real estate sector. And productivity growth has been sluggish.

The signs were evident in the years following the North Atlantic financial crisis. The Chinese government tried to deal with a structural problem with a combination of fiscal, monetary and credit expansion that works better against cyclical slowdowns. Reversing a structural slowdown needs more than stimulus.

The numbers tell the story better. China averaged an annual growth rate of 10.7% between 2002 and 2011. The rate of economic expansion in the 2012-2022 period was 6.3%. Of course, as with most other countries, the Chinese slowdown over the decade has also been affected by the covid shock of 2020. Most economic forecasters expect China to manage only 3.5-4% growth during the rest of this decade. What is especially important is that China has been reporting lower growth over the past decade despite maintaining the same investment rate of around 45% of gross domestic product, a sure sign that the efficiency with which it is using capital is worsening.

The Chinese leadership has recognized the need to move away from an economic model that was so successful till recently—from manufacturing to services, from international demand to domestic demand and from capital investment to consumer spending. Underlying these transitions would be the biggest of them all, from economic growth led by more inputs to economic growth led by productivity gains. This is broadly what Japan did after 1975 and the countries of East Asia managed after 1998.

One of the most important policy initiatives to reinvent the Chinese economic model was announced in 2015. The ‘Made In China’ programme is a ten-year plan to promote ten industries that the government believes are crucial for the future: robotics, green mobility and energy, information technology, high-end railway equipment, power equipment, aerospace engineering, new materials, agricultural technology, maritime engineering and medical devices. These are to be the building blocks of the fourth industrial revolution.

The industrial policy that China is now pursuing is different from earlier episodes of industrial policy in Asia—from the failed Nehruvian experiment in India to successful attempts in countries such as South Korea. Previous attempts at industrial policy in this part of the world were aimed at catch-up growth, so that industries that existed in more developed countries could be built domestically in quick time.

China has a different need. It is trying to build new industries—and standards—that are at the global technology frontier. That has profound geopolitical implications, which is one reason why the US and its allies have been trying to put a technology squeeze on China. There is very little information whether the Made in China programme has been successful. However, a recent paper by Lee G. Branstetter of Carnegie Mellon University and Guangwei Li of Shanghai Tech University, using data extracted from the financial statements of listed companies, shows little evidence that firms receiving subsidies under the Made In China initiative have reported higher productivity, increases in research spending, patenting or profitability (‘Does “Made In China 2025″ work for China? Evidence from Chinese Listed Firms’, National Bureau of Economic Research, Working Paper 30676).

The shift from an economy driven by more inputs to one driven by more productivity is tough, but also essential for China. Its old economic model is now incapable of delivering rapid growth. The Western alliance has learned from its past mistakes and is unlikely to give China access to its latest technology. Can China beat them at that game? It has to pivot rapidly towards an innovative economy. The broader question is whether an authoritarian political system can promote innovation at the global technology frontier. The question that was asked of the Soviet Union will now be asked about China. The political colour of the protests across China is thus important for the future of the Chinese economy as well.