Factors Contributing to China's Economic Growth and Constraints to Future Growth

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China’s economy has undergone extraordinary growth over the past four decades. The country was one of the poorest nations worldwide in 1978 with its real per capita gross domestic estimated to be one-fortieth of the US level. However, the nation has become a vital economic power since it opened up to the world following the end of Mao’s rule (Yang, 2013). The country’s real per capita GDP increased from 5.5% of the US level to around 25% in 2014 (Zhang, 2017). “Through economic reforms, China has become a major trading partner and the second largest economy worldwide” (Zhang, 2017). Dissolution of Soviet-style system, the growth of total factor productivity (TFP), trade liberation and foreign investment has supported China’s rapid economic growth, but the country may face challenges in maintaining the growth due to a labor shortage, aging population and over-reliance on foreign investment.

Dissolution of the Soviet-Style System

The dismantling of the Soviet-style system supported economic growth in China by reducing government intervention. Morrison (2014) notes that China experienced economic downturns before 1978 under Mao’s leadership, particularly, during the Great Leap Forward and Cultural Revolution, periods characterized by massive famine and political chaos respectively. During Mao’s rule, the country-maintained policies that kept it centrally controlled, stagnant, and isolated from the global economy. Besides, the nation limited foreign trade to obtaining products not produced locally from Soviet bloc countries only (Yang, 2013). These policies led to stagnation of the economy because the central government managed and ran most of the economic aspects; hence, there were few incentives for farmers, workers, and firms.

The implementation of free market principles in 1978 opened up China to international markets. The government under the leadership of Deng Xiaoping launched several economic reforms to increase its legitimacy by raising the living standards and economic performance. According to Morrison (2014), economic reforms that started in 1979 improved efficiency and increased output as well as resources for additional investment. The implementation of market reforms made China the fastest growing economy with an average growth of about 10% of gross domestic product (GDP) per year from 1979 to 2012 (Esmail & Shili, 2017). The transition to the free-market economy increased China’s competitiveness by increasing non-state-owned firms.

Total Factor Productivity (TFP)

The adoption of an economic system governed by market forces to replace the collective system contributed to TPF (increased labor productivity) growth, which in turn led to economic development. Iida, Shoji, and Yoneyama (2018) argue that China would not have achieved rapid and sustained economic growth without significant growth in TFP. Under the collective system, farmers’ efforts were not a determinant of income; hence, producers did not have the incentive to put extra efforts, which in turn decreased productivity leading to severe food crises. The government made three changes to reform agriculture: the introduction of a household responsibility system, liberalization of the markets for agricultural products and increased prices of agricultural products (Yang, 2013). China introduced a household responsibility system in 1978 to allow farmers to sell a proportion of the produce at official prices to the government and the excess under market prices. The price system reforms stimulated production, which in turn helped the country to resolve the food deficit. According to Esmail and Shili (2017), China is the largest agricultural economy and the largest producer of cotton, tea, rice, wheat, pork, and fish worldwide. The country produces about 20% of the world’s food and 18%. Around 50% of world vegetables, 29% of meat and 18% of cereals come from China (Esmail & Shili, 2017). The growth in agricultural output alleviated subsistence food constraint and improved economic growth by increasing productivity.

China’s agricultural sector experienced extensive market liberalization, which motivated farmers to adopt new technologies leading to TPF growth. Liberalization of the agricultural markets helped farmers to make their decisions with fewer restrictions and less intervention from the state officials with regard to input. TFP increased from 5.1% to 3.1% from 1978 to 1997 resulting in a substantial increase in the production of grain, which helped the country to reallocate workers to other sectors (Zhang, 2017). According to Yueh (2015), establishment of joint ventures for transfers of technology and knowledge increased GDP by 0.43% to 1% annually. A shift to house responsible system helped the country to meet food demand with a smaller number of farmers than before due to growth in productivity. As a result, some workers relocated to non-agricultural sectors, which increased the aggregate productivity. Over 49 million employees joined other sectors, which led to substantial efficiency gains and enhanced productivity (Morrison, 2014). Most of the workers moved to rural industrial enterprises known as township and village enterprises (TVE) established by the township and village-level governments. TVE is more efficient and competitive in the international markets comparable state-owned enterprises because they are market-oriented and pursue more productive activities.

Heavy reliance on production led to TPF growth. China’s TFP increased by about 3.5% annually from 1978 to 2011 (Zhang, 2017) and accounted for around 40% of the country’s GDP growth (Yueh, 2015). The annual TFP growth in the non-state agricultural and non-agricultural sectors was 4.01% and 3.91% respectively from 1978 to 2007. On the contrary, the growth rates of TFP in the sectors controlled by the government was 1.68% during the same period. According to Iida, Shoji, and Yoneyama (2018), state-owned firms decreased from 10,000 million in the 1990s to 300,000 by the early 2000s due to privatization. The privatization of state-owned enterprises has contributed to an increase in the aggregate TFP level.

Trade and Foreign Investment

Constant opening up was an indispensable factor that explains the massive economic growth. The removal of trade barriers and price controls increased competition of the Chinese firms. The country has entered into several trade agreements with many countries particularly those in Asia. In 2000, the government implemented a strategy that encouraged local firms to invest in foreign countries to obtain management skills, technology, and global recognition to improve their competitiveness. In 2001, China joined the World Trade Organization (WTO), which led to a significant decline of tariff rates and the expansion of trade rights. WTO membership helped the non-state enterprises to enter domestic trade sectors resulting in a significant reduction in trade costs and enhanced productivity (Morrison, 2014). “The government introduced four economic zones to attract foreign investment, boost imports and exports” (Morrison, 2014). Besides, the state designated additional regions at the coastal areas as developmental zones and open cities to offer trade and tax incentives and allow the Chinese to implement free-market policies.

International trade and investment have facilitated Chinese economic growth by boosting imports and exports. Esmail and Shili (2017) note that the value of China’s merchandise imports increased from $18 billion to $ 2 trillion with a growth rate of 16.6% per year from 1979 to 2014. The exportation of merchandise rose from $14 billion to $23 trillion with an annual growth rate of 18% during the same period. “China became the largest holder of foreign exchange reserves in 2013 due to large-scale foreign investment, large purchases of foreign currencies, and merchandise trade surpluses” (Morrison, 2014). Furthermore, trade and investment reforms increased the volume of foreign direct investment (FDI), boosting the growth of domestic enterprises. The annual FDI inflows increased from $2 billion to $108 billion from 1985 to 2008 but decreased by 12.2% in 2009 due to the global economic recession (Yang, 2013). However, China recovered from the economic downturn faster than developed nations, and its FDI flows reached $112 billion in 2012, making it the second recipient of FDI after the US (Morrison, 2014). The number of foreign-invested enterprises in China increased from 2.3% to 35.9% from 1990 to 2003 but dropped to 27.1% by 2010 (Morrison, 2014). In 2011, the foreign-invested enterprises accounted for 49.6% and 52.4% of imports and exports directly (Morrison, 2014). FDIs led to inflows of new processes and technology that led to TFP growth and improved economic efficiency.

Large scale capital investment generated from foreign investment and large domestic savings contributed to a large extent to rapid economic growth in China. Huge savings fostered investment, which in turn supported long-run economic growth. At the onset of economic reforms in 1979, domestic savings was 32% of the GDP in 2008, which far exceed that of the US (9%). Profits of the state-owned firms generated the most savings which were used for local investment (Morrison, 2014). Decentralization of economic production increased both household and corporate savings significantly. Due to this policy, the country’s gross savings reached 53% of the GDP resulting in growth in domestic investment. China’s gross domestic savings are higher than its levels of local investments, meaning that the country has accumulated trade surplus making it a large lender globally.

Constraints to Future Economic Performance

China may face challenges in sustaining its economic growth in the future. According to Zhang (2017), China’s economic growth decreased from historic 10% average annually to 6.9% in 2015, and it is predicted to drop to 3.6% from 2021 to 2030. Morrison (2014) claims that countries with high economic growth rates are likely to slow down when they reach the middle-income level (per capita income that ranges from $1,006 to $12,275). China’s per capita GDP reached $7,575, and thus if it falls it may experience a middle-income trap. Yang (2013) notes that the current economic model has led to negative outcomes such as industrial policies that cause inefficiencies in many sectors, cheap labor, and over-reliance on fixed investment that may affect future economic growth. “Cheap labor and investment have been the key drivers of China’s rapid economic growth, but due to demographic changes, China is currently experiencing labor shortages and rising wages” (Zhang, 2017). The percentage of individuals aged 15 to 65 years increased steadily but began to fall in 2010, which may lead to a decrease in capital returns and labor shortage (Zhang, 2017). The country will experience a decrease in savings due to an increase in the aging population.

Over-reliance on capital investment is another indicator that China may get stuck in the middle-income trap. Fixed investment accounted for more than 60% of GDP growth from 2001 to 2008 which was an increase of 20% from 1990 to 2000 due to high saving rates (Morrison, 2014). Over the last decade, the country’s output ratio has increased meaning that Investment is becoming less efficient. The country has been experiencing a decrease in investment since 2012 due to debts and excess capacity. Besides, private consumption decreased from 48.8% to 36.3% of the GDP from 1990 to 2012 making it the lowest of all major economies (Morrison, 2014). An incomplete transition from centrally-planned to the free market has contributed to over-reliance on investment. Although the country allows the use of free market forces, the government is a key player of economic growth. The number of state-owned firms decreased significantly following the implementation of economic reforms, but they are dominant in several sectors such as transportation, utilities, and telecommunications which protect them from the competition. Banks have made loans easily accessible to state-owned firms while making it difficult for private firms to gain sufficient capital funding to thrive. Industrial policies have also limited the growth and competition of the private sector by lowering the cost of land, water, capital and energy below the market levels (Yang, 2013). The government must encourage rebalancing and a shift towards higher consumption to maintain economic growth.

China’s ability to implement economic reforms, particularly, on collaboration between markets and government to hasten the transition of the country to a free market economy, will help to sustain its rapid economic growth in the future. Yueh (2015) contends that China requires not only human capital and technological improvements but also re-balancing of its economy and reform of the government’s role to sustain growth in the future. Rebalancing will involve boosting local demand (government spending, investment, and consumption) to ensure that it grows more than exports to shift the economy away from agriculture and towards services. Zhang (2017) notes that the Chinese government is making an effort to transform the nature of the economic growth from relying on exports and investments to being driven more by innovation and domestic demand. The country has implemented measures and policies to promote indigenous innovation and reform to bring new drivers for productivity and economic growth.

Conclusion

Economic reforms towards a free-market economy and TPF growth contributed to the rapid and persistent economic growth in China. Reallocation of capital and labor from agricultural and state-owned sectors to non-agricultural and non-stated controlled sector support TFP growth. Trade liberalization and accumulation of capital from huge savings and foreign investment are significant drivers for economic growth. Rising foreign investment, trade liberation, the growth of labor inputs and increased spending in innovation will help China sustain its economic growth in the future. However, the declining growth rate of the labor force, aging population, and over-reliance on foreign investment may limit economic growth over time. The government needs to alter its current economic growth model to increase efficiency and boost competition.

References

Esmail, H., & Shili, N. (2017). Key Factors of China’s Economic Emergence. Mediterranean Journal of Social Sciences, 8(3): 251-257. 10.5901/mjss.2017.v8n3p251.
Iida, T., Shoji, K., & Yoneyama, S. (2018). What Drives China’s Growth? Evidence from Micro-level Data (No. 18-E-19). Bank of Japan. Retrieved from http://boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e19.pdf
Morrison, W. M. (2014). China’s Economic Rise: History, Trends, Challenges, and Implications for the United States. Retrieved from http://www.refworld.org/pdfid/52cfef6b4.pdf
Yang, L. (2013). China’s Growth Miracle: Past, Present, and Future. United Nation Research Institute for Social Development, 7. Retrieved from http://www.unrisd.org/80256B3C005BD6AB%2F(httpAuxPages)%2F2893F14F41998392C1257BC600385B21%2F$file%2FChina’s%20growth%20miracle%200808.pdf
Yueh, L. (2015). China’s Growth: A Brief History. Harvard Business Review. Retrieved from https://hbr.org/2015/12/chinas-growth-a-brief-history

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Factors Contributing to China’s Economic Growth and Constraints to Future Growth

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