More or Less an Efficient Economy

China Economic Quarterly

One of the most basic questions about China's economy today is whether it is becoming more, or less, efficient. Where you stand on this largely determines how bullish you are about China's long-term growth prospects. Unfortunately, this question turns out to be very difficult to answer. Plenty of people have opinions, but backing them up with hard evidence is well-nigh impossible given the poor quality of growth, investment and employment data.

On the plus side, China's boosters can point to the vastly increased role of private industry in the past five years, combined with the closure or rationalisation of many old and inefficient state enterprises. In principle, these developments should lead to greater efficiency. So should all the roads, ports, and telecoms networks built in the last decade, since better infrastructure reduces transaction costs and turnaround times.

All this leads to higher labour productivity, which is a critical component of long-term economic growth. According to the Conference Board, an American economic research company, China averaged 6 per cent annual growth in labour productivity between 1995 and 2002, triple America's rate. A controversial study by consultants McKinsey & Co this year found that Chinese manufacturing productivity exceeds Europe's, and is almost on a par with America's. (That study was based on just 20 firms, however).

Optimists argue that China's very high gross domestic product growth rate over the past 18 months - about 9.5 per cent according to official figures - is largely the fruit of this happy combination of industry restructuring, improved infrastructure and fast-growing productivity.

Not so, say the pessimists. The high growth is simply what happens when the state ladles out huge quantities of free cash to all comers. Since the beginning of 2001, China's banks have issued nearly US$900 billion in new loans, increasing the nation's stock of credit by almost three-quarters. The real interest rate on these loans, always low, is now effectively zero because the nominal lending rate (5.3 per cent for a one-year loan) is about the same as the rate of inflation.

This flood of money has financed vast amounts of investment, but returns have kept going down. Over the past two years, according to some estimates, each US dollar of investment has generated just 20 cents of growth, a return on capital worse than India's, and significantly worse than China's own performance in the mid-1990s.

When money is free, the pessimists note, private companies are not necessarily more efficient users of capital than state-owned ones. Just remember the internet and telecoms bubbles of a few years ago, when private technology firms burned through billions of dollars of investors' money, with very little return.

The main problem is that while it is very easy to point to factors which ought to enhance or diminish efficiency - industry restructuring and rapid loan growth, for instance - it is very hard to measure the actual effects of these factors. Take the simple example of labour productivity. In most countries, this is measured by dividing output by the number of hours worked. In China, one must first guess the number of workers - because employment figures are incomplete - and then guess how many hours they work, because China keeps no figures on work hours. So most productivity estimates have a large margin of error.

In the end, both sides are probably right. Chinese industry is simultaneously growing more efficient and more wasteful. Individual companies are far more efficient than in the bad old days of state planning. However, cheap money means that there are far too many of these efficient enterprises, so that in the aggregate, vast amounts of resources are wasted. On balance, efficiency seems to be winning, but it is a very close race.

(Originally appeared in the August 2, 2004 issue of South China Morning Post in Hong Kong, reproduced here with permission.)