Is China’s productivity miracle over?

By Leith van Onselen

Below is a facinating presentation by UBS’ George Magnus, which examines whether the Asian Miracle is coming to an end.

Magnus’ sections on China are particularly pertinent for Australia. First, Magnus discusses China’s falling rates of productivity:

In China, the higher contribution of TFP to economic growth in the 2000s shows up clearly in Chart 4. Roughly half of China’s TFP growth has come from the transfer of labour from the rural sector to higher value-added, urban-based, jobs, mostly in industrial manufacturing for export.

But in Chart 5, the sequential changes in growth contributions stand out more clearly. The labour contribution is just about drying up, while the investment and TFP contributions are clearly sliding.

The slowdown in TFP growth, along with investment, testifies to the need for reforms to raise the growth and levels of efficiency, and as explained later, to change the contributions and functions of the State vis-a-vis the private sector – probably one of China’s biggest structural challenges in the next decade.

For China and Asia generally, higher sustainable economic growth, based around greater efficiency and innovation, depends on political and institutional reforms. Without these, we believe the miracle could fade and slower long-term growth will result – not a cheery prospect, given high expectations.

Magnus also notes the following about the need for reform in China:

Earlier, we alluded to China’s rapid ageing and labour force consequences, the excessive weight of investment in GDP, and the slowdown in TFP and potential growth. The principal task of rebalancing the economy, as is well understood, is to raise the consumption and personal income shares of GDP, while managing the decline of the investment sector’s weight in and contribution to growth.

As and if this happens, China’s infamous external surplus, which is the difference between savings and investment, and currency reserve accruals should decline permanently. But we see little persuasive evidence that this rebalancing is happening yet. True, China’s current account surplus has fallen from 10% of GDP before the crisis to 2.8% of GDP in 2011, i.e. the imbalance between savings and investment has declined already. Investment has risen for structural reasons, due to strong manufacturing productivity, the relocation of global manufacturing to China and its low domestic cost base. Cyclically though, the main factors were the surge in investment after 2008, weaker foreign demand for exports more recently, and some decline in the terms of trade (higher import prices and real exchange rate).

Shouldn’t we expect this sort of rebalancing to continue? As China’s urbanisation rate rises, aggregate consumption should increase. Rapid ageing and labour market effects should push real wages up and lower aggregate savings. And slowly, government policies designed to bolster income security and transfer income to people with a high marginal consumption propensity, should also help to lower savings. In the last 3 years alone, access to primary healthcare has improved, especially in rural areas, the government has acted to achieve universal health insurance by the end of this year, government pension schemes have been expanded and made more flexible for job changers, and a major social housing programme is underway.

At the same time, the growth of fixed asset investment has been slowing down to a near 5 year low (20.4% in the year to June). It portends weaker growth in real capital investment growth to levels that are more in line with or a bit higher than real GDP growth. Last year, the increase was around 9%, down from 19% recorded in the wake of the 2008 stimulus programme. The monthly fixed asset numbers will soon tell us if the government’s latest moves to ease monetary and credit restraints and spur new infrastructure investment are succeeding in stabilising the investment rate, or failing regardless.

Unfortunately, there aren’t strong reasons to expect current savings and investment trends to linger, and absent a major change in economic direction, China’s surplus is likely to start expanding again before long…

There is certainly no evidence that aggregate household savings are declining as a share of GDP, or that the aggregate consumption share has started to rise from a deep trough – regardless of the buoyancy of retail sales…

The slowdown in investment growth, as such, is welcome. But the danger is that easier financial policies and higher infrastructure spending approvals will simply prop up a model that is sustaining uneconomic levels of production and investment…

Magnus then concludes the following about China:

One way or another, China is going to rebalance. The question is whether it occurs in an orderly fashion with the investment side of the economy slowing to a rate less than the growth in GDP, but still growing. Or whether it happens in the context of a sharp decline in investment, with more alarming economic and political consequences that will cut across the economy.

After two decades of unparalleled economic success, we believe China now needs a reform programme on a scale similar to that adopted 30 years ago. Without it, a heavily investment-centric and credit-intensive economic model could soon become unstable, and later stall in a middle income trap. There’s only so much labour transfer from rural areas to urban factories. There’s a limit to how high the investment share of GDP can go. Rapid population ageing is chipping away at Chinese growth. The exceptional impact of accession to the WTO a decade ago is fading. And the significant, direct role of the government, state banks and SOEs in the economy as agents of economic policy, and owners and providers of heavy investment and infrastructure may no longer be appropriate as the economy becomes richer, more complex, and in need of greater competition and innovation.

In our view, the bottom line about reform is whether the CPC is willing and able to do three fundamental things. First, we feel it should move towards a fuller market economy, changing the legacy role of the state. Second, it should allow power to drain from itself, regional governments, state entities and the  military towards the private sector and households. And third, it should introduce rules and transparency, including adoption of the rule of law, into the overall system of governance.

You can be optimistic or pessimistic about the outcomes, but you can’t speak of the China or, by implication Asia, miracle nowadays, without considering the chances of successful political and institutional reforms. More to the point, perhaps, what would the consequences be for China if, for existential reasons, the CPC wasn’t willing or able to go down this path?

Asia is the Miracle Over – George Magnus UBS

Unconventional Economist
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  1. Wow. That is pretty devastating to the endless investment camp. I reckon China will reform successfully to resume its productivity growth through moving up the value chain but he’s still right, it will rebalance accordingly.

    China could be fine and we would have a serious problem.

    • I am surprised your not mentioning former PM Rudd’s musings on China from the World Economic Forum – he spoke to Leigh Sales last night on the 7:30 Report.

      He mentions the coming off the boil of China – but calls it a modest slowing; not a disaster and views it as a ‘soft landing’ and with growth of more than 7% a year and stimulus spending to come and with the high population numbers, growing middle class – the medium to long term looks very good. I agree with Mr.Rudd.

      • You are entitled to your view. However, it looks like Rudd is simply stating the “company line”. Interestingly, the Financial Times contains a good report on the WEF meeting, which contains the following quote:

        In contrast to the optimism of many international attendees in Tianjin this is what one highly respected Chinese economist told the FT:

        “I believe China is going to experience a very serious economic downturn and I think it has already started. The government is trying now to stabilize the economy but the instruments they have are very limited. If it can’t turn things around then I expect huge and widespread social unrest.”

        The striking views of this economist, who asked not to be named because he did not want to offend his superiors in the Communist party, are surprisingly common among Chinese academics and officials who just a couple of years ago were still very bullish on the country’s prospects…

        While many in the international business community seem to credit China’s leaders with superhuman powers of wisdom and foresight, those on the inside are much more sensitive to the inefficiencies and perversions of a system that lacks an independent legal system or a transparent mechanism for economic and political decision-making…

        After a series of private meetings with Chinese officials and analysts at the WEF this week one senior executive from a very large western fund manager told the FT that he was doing just that [reassessing his assumptions about what is going on in the Chinese economy]:

        “After what I’ve heard I’m really worried now about being the dumb foreigner sitting across the negotiating table from the locals who are packed and ready to run to the airport.”

        Who do you believe? Rudd or the Financial Times?

        • I do believe both actually UE – I believe a winter is about to come upon us all – USA, UK, EUROPE and Australasia as de leveraging has to take place. But I do concur with Rudd, that in the medium to long term, business in China will prosper – it has to, as has been mentioned, for social cohesion and the huge population. The short term does look bleak, especially for the West – but China will react quicker, stimulating and stockpiling. I also believe in cycles and seasons and that in the end it will work out and during the hard times, we can communally help one another, as they are doing now in Greece, Spain & Portugal – perhaps harder in OZ to do that, but we will have to learn!

    • It’s also devastating to the never ending mantra around here that we will always be able to import cheaper and cheaper goods to offset our rampant non-tradables inflation.

      I’d also add (repeat)that there has been a great effort for some time to re-orient the Chinese economy. It’s in process. As I’ve said before the place is so huge that it doesn’t show up for a while. You need to be traveling in smaller cities and towns, drinking Moutai with the locals at SME enterprise level, to appreciate the fact.

  2. HnH the key question I suggest is whether China can move up the value chain whilst still keeping the Party in power.The benefit of the current model is that huge capex intensive SOEs allow patronage to flourish and the party can buy itself a continuing role.If China moves to a more entrepeneurial model with IP protection and a rule of law approach, how does the Party keep its grip on the sinecures that are vital to its hold on power?.Put another way, maybe the political model and the economnic model are tightly bound together-which is I think the point of Magnus’s last sentence.

    • Yes – although there is an expressed desire to re-balance the chinese economy that is a lot easier said than done.

      There are very strong political connections to the economic status quo. Very influential people within the CCP control and benefit from those export orientated industries and fixed investment construction companies.

      The Japanese have long struggled to limit the political influence of the concrete construction and export industries and Europe is choke full of daft agricultural policies that produce expensive food for the population to benefit the ag sector. The USA sugar industry and ag generally is another example.

      The leaders of the CCP party and the informed technocrats may very well understand the medium-long term importance of re-balancing but since when has that been a guarantee that sensible policy will result when large financial interests are at stake.

      We don’t have too look far from home to see how difficult it can be to wean an economy off a familiar teat.

    • Something I am forever going on about on here, and no-one else seems to mention, including on this thread, is the insane levels of “gain” that CCP officials make on urban development in China. This leads to massive distortions in the entire urban land market and from there, into the whole economy.

      The underlying economic mechanisms are the same as what has caused housing bubbles everywhere so far; the actors just have different labels in different countries. “Smart growth” is the same thing, only without a CCP.

      Chinese urban land is starting to look as stupidly over-valued as Japan’s was in the 1980’s. And that did not have nice outcomes.

  3. Thanks for that UE – hadn’t seen that one. Very very interesting and well illustrates the likely challenges China may face.

    Long term it seems almost impossible to see how economies will juggle the adverse effects (constant reallocation to cheapest provider) of the globalisation juggernaut – will some of what Magnus writes mean that eventually some/much of Chinese manufacture will itself shift offshore – giving rise to a new “tiger”; or will some economies reignite domestic production; and where will all of it leave a small open economy like our own?

    With our abundant natural resource base (agricultural and mineral) of course – but what else?

    • 3d1k There is NOT another China in the world. Even further there is not another Se Asia. This particular cycle, now some 50 years in process, is now very mature!

      ‘where will all of it leave a small open economy like our own?’

      There are about 6 people in this country asking that question you, me, DE, Rumples, Flash and a handful of other posters here.

      I suspect the US will re-ignite domestic production. I’m having trouble seeing how anyone else can in under a period of multiple generations.
      I guess if the pain is enough things MIGHT change. So far the indications are we will sit in our own mess and whine.

      • Flawse – off shore manufacturing will and is already going to Africa and it is being implemented by the Chinese. It’s that $2 a day Labour that is so attractive to the Chinese! The Chinese are buying up heaps of Africa’s mines and whole sale business – food & minerals and they have started manufacturing, but the work ethic of the Africans is challenging the work a holic Chinese. ( See Niall Ferguson doco.)

        • The other place that some economic activity is “moving back to”, is Southern USA where urban land costs are far lower than in China’s cities. Lower, in fact, that practically everywhere else in the world. It is crazy that Australia has not woken up to the fact that it could get itself that economic advantage too if it just tossed the b—-y idiot Greenie urban planners out of local and State government.

          • I don’t know Phil. I suspect the whole country has gone into some moronic self-entitled daze!
            I don’t think it is reversible.

          • Hi Phil

            Even going back maybe 12 to 15 years ago, when wages in China were much much lower, another Taiwanese friend moved his factory to Georgia (or South Carolina). He was originally planning to move it to Xiamen Wages were $4.50 an hour (about 1/3 wages here in Aus)and he bought a factory building for nicks.
            There will be more of it I would say.

          • PhilBest,
            “The other place that some economic activity is “moving back to”, is Southern USA where urban land costs are far lower than in China’s cities.”

            I am living in Nashville, Tennessee and am in recruiting. I can tell you all this there is a ton of manufacturing companies coming back to the southern part of the US. The other side of it is the Southern People hate the Unions. Alot of companies up North are moving down here. I cant tell you how many Northners live here in Nashville now. I am 40 years old and when I was growing up here there wasnt that many Northerners. Well Yankees they are called Yankees/Yanks. If you ever visit the south dont call them Yankees in the Southern states guaranteed you will get in a fight or get shot or politely told I am not a Yank. 🙂

          • That is very confirming, thanks Flawse and LBS. The information I am following with interest comes from sources I very much respect: EMSI (Rob Sentz); Policom (William Fruth); and Joel Kotkin. These guys all seem to understand the role of zoning and land use regulations as well as the other stuff that most people know.

        • neil re work-a-holic Chinese
          Yes! That’s exactly what i mean. There is NOT another China in the world. They are a highly intelligent, well educated,conscientious, prudent people.

          A Chinese friend of mine moved part of a factory from China to Vietnam. The only real problem he had was that, even with the hard working (relatively) Vietnamese he had to employ two people for every one in China.

          We are not going to get a revolution in costs and production of the sort of the sort that China has provided again. I’m coming from the direction of a long-term cycle as far as inflationary expectations go for Australia. For about 50 years we have had the cheap goods from Asia story holding down our inflation while we paid ourselves more. I think it is pretty obvious that is coming to an end.

          There is hardly an analyst in the whole of Australia looking at the problems that will arise for us as a result of Chinese demographics and prosperity.