China's Third Arrow Productivity Trap

The mix of asset ownership and control continues to shift into China's low productivity State sector

While China is not Japan, by my reckoning the comparisons have now become too close for comfort.  In the face of China’s deepening economic malaise, this is not the time for Beijing to split hairs over the distinctions — it should, instead, err on the side of acceptance rather than denial.  Accordingly, I feel it makes better sense to view China’s policy options through the three-arrow lens of Abenomics, Japan’s signature plan for economic revival. 

I argued recently in the Financial Times that China’s recent stimulus package is especially deficient from a third-arrow perspective in failing to address the nation’s serious structural growth problems. It is widely believed that productivity holds the key to any nation’s longer-term structural growth trajectory. The Chinese leadership has long accepted this basic premise.  The “supply-side structural reforms” of the Xi Jinping era are one of the more recent examples of China’s productivity focus.  The same can be said for an earlier celebrated warning of Japanese-like productivity perils by an “authoritative person” on the front page of People’s Daily in May 2016.

If anything, my concerns about the Japanization of China continue to deepen. A recent update on the shifting mix of Chinese enterprise ownership paints an especially worrisome picture of one of the most daunting aspects of China’s productivity problem. According to researchers at the Peterson Institute of International Economics, the private sector share of the equity market valuation of Chinas top corporations fell to 33.1% in mid-2024, down sharply from the peak share of 55.4% hit as recently as mid-2021 (Figure 1). It follows that the state-owned portion (wholly State-owned enterprises (SOEs) plus so-called mixed-ownership SOEs) has now risen to nearly 67%, fully double that of the private sector.

Source: T. Huang and N. Veron (PIIE, Sep 2024)

Notwithstanding obvious caveats to these figures — namely, that they pertain only to China’s top 100 listed companies, whose valuations rise and fall with an equity market that has gone from bust to boom in the past few weeks — there can be no mistaking the widely documented swing of the enterprise ownership pendulum during the Xi Jinping era. It’s not just the CCP’s “unswerving” commitment to the importance of the State’s ownership and control of assets, it is also the severe tightening of regulatory restraints imposed on the once dynamic private sector that have been evident since mid-2021.

There is another key piece to this puzzle — China’s low-productivity SOEs.  A recent paper by IMF economists underscores the productivity and profitability disparities that have opened up since 2002 between high-productivity private companies and publicly listed low-productivity SOEs (Figure 2 below). Other researchers, including Nicholas Lardy, Franklin Allen, and Hamming Fang, have come to similar conclusions.  Low-return, low-productivity SOEs are consistently found to stand in sharp contrast with the higher-return, higher-productivity private sector.

That underscores the essence of China’s third-arrow productivity trap. The recent shift on the mix of enterprise ownership is skewed toward low-productivity SOEs.  This seriously compromises any impetus to national, or aggregate, productivity growth.  As was, and still is, the case in Japan, productivity imperatives are especially important for nations facing demographic constraints on their working-age populations.  That’s because productivity leverage is the only way to squeeze more out of diminished labor input.

Japan’s working-age population peaked in 1994 (its total population peaked 2009), whereas China’s working-age population peaked some twenty years later in 2015 (its total population peaked in 2021). China’s recent efforts to boost its working-age cohort by a small increase in its retirement age hardly move the needle. Japan failed to address its work force problems for a variety of reasons — cultural, institutional, and political.  For different reasons, the same fate may await China.  However, in both cases the economic growth implications are equally powerful: a peaking out of labor input has been exacerbated by declining total factor productivity.  

Therein lies an important lesson for China. Japan’s first lost decade of the 1990s reflected the twin pressures of aging and weak underlying productivity. The result was a structural vice on Japan’s growth potential that ultimately led to three lost decades of relative stagnation in economic growth, with average GDP growth in Japan decelerating dramatically by about six percentage points from 7 ¼% over 1946-90 to an average pace of just 0.8% from 1991 to 2023.  

Fast forward, and China is facing a very comparable set of circumstances — namely, the lack of a productivity offset to counter a demographically-induced shrinkage of its working-age population. Moreover, repeating a point I made on September 27 (see Figure 3 below), China’s coming growth deceleration is strikingly reminiscent of that which afflicted Japan;  according to the IMF’s latest forecast, average Chinese  GDP growth is also expected to decelerate by about six percentage points, slowing from the blistering 10% pace of 1980 to 2010 to a projected 3.9% pace over the 2024-29 interval.

The pushback I often get from this comparison is typically framed around the comments of, “What’s so bad about 4% growth?” After all, it would still leave China growing at about four times the pace that Japan recorded during its three lost decades.  I like to think of this in terms of an analogous deceleration of a fast-moving car: When a Chinese vehicle slows from 100 miles per hour to 40 miles per hour, it may well feel the same as a Japanese car slowing from 70 miles per hour to 10 miles per hour.  In both instances, the passenger is thrown against the metaphorical windshield.

My point is that the “gravitational” impacts of equally sharp growth shocks are especially important. Once the shock sinks in, it alters fundamental perceptions of the growth bargain between political leaders and society — businesses and individuals, alike. For China, that spells a serious challenge to the hopes and aspirations of the Chinese Dream, the bargain that Xi Jinping first struck with the Chinese people in late 2012.  To the extent that China’s growth shock cannot be effectively countered by productivity-based resilience, especially due to the shifting mix of enterprise ownership into the low-productivity SOE sector, the political economy of XI Jinping’s growth bargain may well be compromised.

Yes, there are important differences between China and Japan. But consistent with the warning of  China’s own “authoritative person” eight and half years ago, the similarities of debt-intensive, asset-dependent growth are far too striking to ignore.  Mindful of the persistent downside risks to its economy, Beijing policymakers are continuing in their efforts to tweak the big-bazooka-like stimulus announced September 24.  However, consistent with the experience of Japan, it will ultimately take three arrows to cure the disease.  Without solid productivity growth, China will have an exceedingly difficult time achieving traction with weak third-arrow solutions to structural problems.  Just like Japan.