Author's Response: Assessing China's Potential Growth

Abstract

Author's Response:Assessing China's Potential Growth Nicholas R. Lardy (bio) The commentators on The State Strikes Back: The End of Economic Reform in China? for the most part agree with the first of the two key themes of the book: that the increased role of the state in resource allocation in recent years has been an important contributor to China's slowing economic growth. They mostly disagree with the second key theme: that since China's level of GDP per capita is only about one-quarter of the level of advanced industrial economies, it potentially has substantial room for convergence toward higher levels of development that might be captured by a return to the more market-oriented economic policies of the past. In this response, I will focus on addressing some of their concerns around both of these themes. The State Contribution to China's Slowing Growth Loren Brandt focuses in his review on the state's role in the economy. He acknowledges that productivity growth in the state sector has slowed, but he argues that the most important reason for China's slowing economic growth is the declining productivity of private firms. In support of this, he points to research showing how productivity growth in industry slowed after 2005 and eventually turned negative. Industry, he contends, is largely private, so the productivity growth of private firms must have fallen. There are two problems with this approach. First, in 2005, one-third of value added in industry was contributed by state firms.1 The decline in return on assets of state firms by two-thirds after 2007 may explain most of the downturn in industrial productivity that Brandt reports. Second, Brandt's approach ignores China's service sector, which as early as 2005 was as important as industry in terms of its contribution to output and is much more heavily dominated by state firms than industry. But the return on assets of state service companies is lower than for state industrial firms and also fell substantially after 2007. [End Page 174] Brandt questions the use of return on assets, which looks at profits relative to assets, as a proxy for productivity—a measure of value added in constant prices relative to an appropriately weighted basket of assets and labor. For two reasons, however, the sharp decline in the return on assets of state industrial firms relative to private industrial firms is a good proxy for underlying trends in the productivity in firms of the two types of ownership. First, to claim that the productivity of state firms did not fall relative to private firms after 2007, one would have to show that there was some combination of accelerated employment growth relative to assets in private industry and an unusual slowdown in employment growth relative to assets in state industrial firms. Second, Brandt also points out that changes in market power can influence profitability and thus the return on assets, making the latter an unreliable guide to underlying productivity. But the consolidation of large state firms under the State-owned Assets Supervision and Administration Commission, established in 2003, likely gives state companies more influence on pricing relative to the influence of private firms. This suggests that the data in the book showing a sharp decline in the return on assets of state companies understates the pace of deterioration in their underlying economic performance. The Potential for Convergence China faces three potential headwinds that were absent or possibly less significant in the other East Asian economies that converged toward advanced-economy levels of per capita output—demographics, the environment, and corruption. One or more of these is mentioned by each of the reviewers. Kenneth Pomeranz refers to the demographic issue of China's workforce. China's ratio of the working-age population to the non-working-age population began to decline in 2010, a trend that will continue for at least two more decades. Other things being equal, this is certainly adverse for China's potential growth. But other things need not be equal. Most importantly, as I point out in the book, China has a very low labor force participation rate among older age cohorts. This is a function...