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Can China Transform its Mode of Growth?

Tags Free MarketsGlobal EconomyMoney and BankingOther Schools of Thought

06/23/2009Mark A. DeWeaver

Practically since the beginning of the "reform and opening" period in 1978, China's central government has sought to shift from an extensive to an intensive development model — from growth based on capital accumulation to growth based on improvements in productivity. This year, however, while the planners continue to talk about the need for this long-sought-after transformation, they are moving in exactly the opposite direction, counting heavily on state-sponsored investment to keep the economy growing in the wake of the global financial crisis.

This is not surprising as they have had little success in transforming China's mode of growth, even under much more favorable circumstances. While this objective has been emphasized in every five-year plan since 1981, gross-fixed-capital formation has risen from 33% of nominal GDP in that year (as calculated by the expenditure method) to 42% in 2007.

A Missed Opportunity

Perhaps the best opportunity there has been to make progress on this issue came in 2001, the first year of the tenth five-year plan, which called for "taking structural adjustment as the main line." At that point, it could be argued, China had reached the level of self-sufficiency in industrial raw materials necessary for such a strategy to be feasible. And by then the unsustainability of the traditional model was already quite clear. In an address to the March 2001 meeting of the National People's Congress, premier Zhu Rong-ji even went so far as to say that "further development will be impossible without adjustment." Continued investment-driven growth, he argued, would only result in excess supply and put an unsupportable burden on China's resource base and natural environment.

But even with such unambiguous central-government backing, no adjustment was forthcoming. In fact, from 2001 to 2007 the ratio of gross-fixed-capital formation to GDP actually rose by four percentage points. And despite the tenth plan's call to reduce overproduction, redundant investment has led to severe overcapacity in a number of sectors. Excess capacity has been estimated at 50% or more for automobiles, ferrous alloys, and semiconductors, and 30% for steel. The latter translates into about 180 million tons per annum — greater than total US annual production!

Chinese economists generally attribute this policy failure to the difficulty of "system reform" — administrative change designed to increase the efficiency of the state sector — but seldom have much to say about why this is so hard to achieve. Their reticence on this point is not surprising, as the root of the problem is China's authoritarian regime itself.

Decentralized Knowledge

Any attempt at economic rationalization will inevitably meet with strong resistance from powerful people who stand to benefit from preserving the status quo. For example, local officials have for years blocked attempts to close small, inefficient plants that create economic growth in their jurisdictions and thereby improve their career prospects. Similarly, central government directives to avoid redundant infrastructure projects are often all but impossible to carry out because of the opportunities such investment affords the well-connected to "wet their beaks."

A more fundamental problem has to do with the nature of intensive growth itself. Unlike extensive growth, which is at least amenable to central planning, the innovation required for intensive growth relies on what Hayek referred to in his seminal 1945 paper on "The Use of Knowledge in Society" as "knowledge of the particular circumstances of time and place."

This type of knowledge, he pointed out, is "dispersed among many different individuals" and "by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form." Thus, as the Austrian economist Randall Holcombe put it in his 1998 article, "Entrepreneurship and Economic Growth,"Download PDF "central planning precludes entrepreneurship, which is necessarily decentralized in nature."

Clearly the central government cannot carry out a strategy based on improving productivity growth in the same way that it could implement an extensive growth policy such as increasing petrochemical production or expanding the railway network. Intensive growth can really only be carried out by the "man on the spot" (as Hayek put it) as only he is in a position to notice the opportunities for the necessary innovation.

The Leadership of the Party

Not only this, he must also have the right incentives, and in China these are often missing. While there is no shortage of Chinese entrepreneurs, their efforts tend to be directed as much toward improving relationships with local officialdom as with increasing economic efficiency. In many cases, as Mises wrote in 1949 of the totalitarian systems of his day, "social competition manifests itself in the endeavors of people to court the favor of those in power" rather than in attempts to build a better mousetrap.

While Chinese officials continue to emphasize the "new" strategy of moving towards intensive growth there is thus no reason to expect that this will be possible even once the situation has gotten "back to normal" and infrastructure spending is no longer necessary to support the economy. The problem is not really economic but political. And as long as "the leadership of the Party" and "Marxism, Leninism, Mao Ze-dong thought" remain enshrined in the preamble to the Chinese constitution, the solution is likely to remain as elusive as ever.


Contact Mark A. DeWeaver

Check out www.markdeweaver.com for more commentary by this author. Mark A. DeWeaver, PhD, CFA, is a cofounder of the fund management company Ithaca Advisors, LLC, and the author of Animal Spirits with Chinese Characteristics: Investment Booms and Busts in the World's Emerging Economic Giant