China had a stunning run, enjoying double-digit economic growth for 30-plus years after initiating market-oriented reforms in 1978. More recently, though, growth has slowed. Some easing as the economy reached middle-income status was almost inevitable, but in China’s case the drop-off has been very sharp. In the five years ending in 2008, China averaged nearly 12 percent growth; in the most recent five years, just half of that.

It is not possible to accurately predict how the economy will fare in the next decade or two because there are so many domestic and international unknowns. But we can examine the strengths and weaknesses of the economy and identify the reforms probably needed to put China’s drive for rapid growth back on track.

Productivity in China (compared in terms of purchasing power) is only one-quarter that of the United States, implying there is a lot of room left for convergence. Here, I will focus on four sources of weakness that must be conquered for China to navigate the catch-up:

• Low fertility, triggered by the now-defunct one-child policy, means that the China’s labor force has peaked in size and will now decline.
• While China is fortunate to have high savings that sustains high rates of investment, there is mounting evidence of inefficiency in the allocation of capital, leading to sharply diminishing returns.
• Beijing recently cracked down on hightech firms, threatening to chill innovation.
• While China’s role in international trade remains strong, the lingering U.S.-China trade war threatens to restrict access to both global markets and foreign technology.

Demography as Destiny?

China’s demographics have been affected by its one-child policy. Fertility — hence population growth — had been high in much of the pre-reform period, but was already coming down when the one-child policy was introduced. As household incomes grow and girls are educated, it is natural for fertility to decline. But this process was helped along by a strict policy of permitting urban couples to have only one child and most rural couples no more than two.

Note that the resulting collapse in fertility gave rise to a “demographic dividend.” The labor force continued to grow because of earlier population growth. But there were as yet few old people, and the size of the youth cohort was declining in relative terms. This meant that a rising proportion of the population was of working age, providing a strong foundation for rapid growth.

Now the process is running in reverse. The elderly population is increasing because higher living standards have extended life expectancy. Meanwhile, the working-age population has peaked and is starting to decline because fertility is below replacement level.

As a rule, it is hard for an economy to grow rapidly when the labor force is shrinking, but there is one important mitigating factor in China’s case: rural-urban migration. China began economic reform in 1978 with only 18 percent of its population living in cities. This was enforced by a strict household registration (“hukou”) system. China needed more urban workers, but did not want to give up the control inherent in the hukou system. Thus was born the migrant worker system.

Rural-registered adults could move to cities as long as they had jobs, but they did not automatically become full urban residents entitled to social services — or, in many cases, housing. Those who worked in construction lived on the construction sites. Employees of large manufacturers lived in dormitories. And if there was a downturn in the economy, migrants who lost their jobs were expected to return to their villages.

Looking at who actually lives in cities (not formal hukou registration), the urbanization rate went from 18 percent to over 60 percent during the four decades since the start of the economic reforms. About 280 million of this urban population consists of migrants. Note that the migrant worker system offered certain advantages from a macro perspective (at great cost to the migrants) because it allowed for the rapid expansion of the urban labor force without burdening the government with the cost of expensive urban services.

All told, the urban prime-age population (ages 25-54) increased from 100 million in 1990 to 400 million in 2020. Urban workers in industry and services are more productive than rural farmers, so this reallocation from low-productivity to high-productivity employment proved a potent source of China’s rapid growth.

What happens now depends a lot on prospects for ongoing rural-urban migration. The projections in the figure combine UN population projections for China with the assumption that the urbanization rate continues to rise, reaching 77 percent by 2050. In this scenario, the urban prime-age population will be stable for several decades but will eventually decline.

The important takeaway here is that rapid expansion of the prime-age urban population ended right around 2020. The best China can do now is stabilize the urban workforce, rather than see it immediately decline.

Managing even this will probably take further reform. The hukou system has been breaking down in small cities, but is still quite rigid in the flagship cities that have the highest productivity. China would postpone the day of urban labor-force decline by eliminating the system and providing all urban residents with social services.

There is also the issue of educational differences. Young people raised in the countryside receive, on average, three fewer years of education than their urban counterparts, and in general the quality of their education is poor. Closing the education gap is a matter of efficiency as well as social equity because, as China becomes a more developed economy, the labor market increasingly demands workers with skills.

China could also facilitate migration and make agriculture more efficient through rural land reform. Farmers now have very incomplete use rights over their land: among other drawbacks, they lose their rights if the whole family moves to the city and does not farm the land. From the point of view of the rural economy, this inhibits efficiency gains linked to increases in scale and mechanization. From the point of view of potential migrants, a system in which they could sell their rights would give them a “first pot of gold” to start their life in the city.

Much of the income inequality in China results from glaring rural-urban differences in productivity and living standards, as well as differences between urban full residents and migrants. A pro-growth policy to achieve “common prosperity” would center on dismantling the hukou system, providing urban migrants with public services, increasing investment in rural education and strengthening farmers’ property rights over land.

Capitalism Without Markets?

As previously discussed, overall productivity growth in China has been in part driven by the movement of low-productivity agricultural workers to higher-productivity jobs in cities. An analogous reallocation took place with capital. But here, the shift was not geographic, but rather from governmentcontrolled enterprises to private ones.

Note that the overall capital stock was growing very rapidly — at about 10 percent annually throughout the reform period. So the government did not have to actually take resources away from state firms in order to facilitate rapid expansion of the private sector.

When China joined the World Trade Organization in 2001, 65 percent of manufacturing assets were in the hands of state enterprises, with which they produced 50 percent of the output. Ten years later, the state share had declined to 40 percent for assets and 25 percent for output.

This direction of change was deliberate: in the 1990s, China had legalized the domestic private sector and opened up to foreign private firms. But the extent of the shift was probably not. China’s trade and investment reforms, combined with a robust global economy, led to an extraordinary surge in exports. Most of the direct exports came from firms benefiting from foreign investment. But these export-oriented firms built robust backward linkages to Chinese private suppliers, so that most of the value added in China’s exports came from the domestic private sector. An export- oriented strategy was thus implicitly a pro-private-sector strategy.

This dynamic came to an end with the global financial crisis. The global economy — and hence China’s exports — were weak for several years. This slippage in export-led growth was compensated to some extent by rising domestic consumption. Compared to exports, however, consumption relies more on services. And, unlike manufacturing, China had left most of the important service sectors — telecom, airlines, media, finance — in the hands of state enterprises.

These state-dominated sectors were all increasing their share of the economy. Plus, the government leadership decided that in manufacturing it would consolidate some of the state enterprises in order to create globally competitive firms in upstream sectors such as shipbuilding, steel and chemicals. As a result, the trend toward a declining state share in manufacturing ended around 2010. Indeed, the private-sector share of the economy has stagnated in the decade since.

Consider, too, that part of China’s response to the financial crisis was a massive program to stimulate the economy through infrastructure investment. This was also state-directed finance aimed primarily at transport and water projects. The big-ticket item was the development of a vast, high-speed rail network.

China stands out among countries in having a huge infrastructure stock, about three times as large as in the U.S. relative to GDP. Now, the U.S. certainly has its infrastructure deficiencies, and much of China’s infrastructure is impressive. But it appears that China overinvested, and that this is one factor in the growth slowdown. The initial lines of highspeed rail, for example, served densely populated corridors and are widely used. However, more recent investments have extended the network into sparsely populated areas where there is little demand.

It is telling that the Chinese government has overinvested in public capital and under-invested in public services. The agenda laid out in the previous section — of hukou reform, more services for migrants, more finance for rural communities — could be paid for by cutting back on wasteful infrastructure investment.

Some decline in returns is natural as capital is built up, but in China’s case the drop-off has been precipitous. At the macro level, the growth rate of the capital stock has been around 10 percent for a long time, and for much of that period GDP growth was also about 10 percent. But with the pace of accumulation continuing, GDP growth has now declined to around 6 percent, and looks likely to be heading lower. At the enterprise level, the real return on capital declined from 15 percent to just 5 percent over the past 20 years.

Comparative studies find capital productivity in private firms to be almost twice as high as in state-owned ones. Hence one policy that would tweak capital productivity would be to rein in state enterprises and to favor the private sector — as occurred in the 1990s and 2000s.

Meanwhile, the capital markets are underdeveloped. Listing on the stock exchange is a bureaucratic affair that requires multiple approvals. It is difficult for private firms to list, and at the same time households are reluctant to put their savings into the market because it lacks transparency and seems too much like a gambling casino.

Households keep considerable savings in the banks, which funds bank lending. But households keep a striking 75 percent of their wealth in real estate. They hold apartments not just for living, but also for investment and speculation. This is probably another factor in the decline of capital productivity: empty apartments do not add to GDP.

The reform agenda that would produce a more efficient allocation of capital is straightforward, but politically difficult. Even with the consolidation that has taken place, there are still a lot of state enterprises owned at the local level — usually by city governments. China could reduce the number of sectors in which state-operated enterprises are allowed to operate and force local governments to divest others. Opening more sectors to foreign investment, as China has done with investment banking and electric vehicles, would be helpful as well. In the capital markets, firms that meet standards should be allowed to issue bonds and stocks. But all of this is controversial in China, because it would remove some degree of the government control over the allocation of capital.

Tightening Beijing’s Grip on the Private Sector

Since November 2020, there have been a number of high-profile regulatory crackdowns on major tech firms. First under the gun was the fintech colossus Ant Financial: Regulators pulled the plug on its IPO at the 11th hour. Just days before, founder Jack Ma had criticized regulators publicly for an excessive focus on minimizing risk rather than promoting innovation. Soon after, the ride-sharing giant DiDi had its wings clipped: after its IPO, regulators intervened to stop the company from signing up new users. There were also new regulations for Meituan online shopping and delivery, mostly restricting use of customers’ data.

Then, too, China banned online tutoring in subjects on the school curriculum. The ostensible reason was that this industry made life more difficult for Chinese students and parents by encouraging excessive study and academic competition. Families were spending more and more to help their children get ahead, and the leadership worried that the cost of raising children was discouraging reproduction (fertility again hit a new low in 2021).

All of the tech firms facing new restrictions are private, and among the most innovative in China. The online financial services — via Alibaba and Tencent — reach poorer, underbanked households as well as small and medium enterprises, thus counteracting some of the biases of the formal financial system noted above. Clearly the authorities wanted to rein in the independence of these digital platforms.

Some internet companies have been forced to shut down, while others are suffering from huge losses or disappointing earnings. Many publicly listed companies have seen their share prices fall by half, if not more. A good summary indicator is the Hang Seng Tech Index, which includes most of these firms. It is down by one-third over the past year, compared to a decline of 14 percent for the overall Hang Seng Index.

These regulatory moves came at the same time that the top leaders in Beijing have been talking publicly about the goal of “common prosperity.” As noted, policies to integrate rural and urban services and labor markets could reduce inequality and foster growth at the same time. But the common prosperity agenda may include constraining the wealth and independence of China’s big tech entrepreneurs, which would inevitably dampen innovation in this sector.

To be clear, some of these digital firms had been lightly regulated, and there are legitimate issues of data privacy and anti-competitive practices. But the sudden tightening of regulation without warning or consultation was an awkward way to address gaps in supervision.

An important question is whether the regulatory crackdown will spill over to the whole private sector. Throughout 2021, private investment grew at a healthy rate. So, in the statistics, there is no sign of a general reining in of the private sector — though, as noted, its share of economic activity has been limited for the past decade.

Foreign investors also continue to flock to China. Inward foreign direct investment was up 14 percent in 2021, hitting a new high. This was encouraged by further modest liberalization of rules governing FDI. The “negative list” of sectors with restricted FDI was shortened, with the most visible liberalization in recent years in automobiles and financial services. In both sectors, limited foreign investment had been allowed through joint ventures with Chinese companies — usually state enterprises. This was the structure that led to complaints about “forced technology transfer,” as investors were pressured to share technology with Chinese partners who were also their competitors. With the liberalization allowing 100 percent foreign ownership in automobiles and financial services, there has been a surge of new investment from international firms.

The evidence to date is that the top leadership is not trying to strangle the private sector. Rather, it is showing its preferences for innovation and investment in areas such as high-tech manufacturing, heavy industry such as autos and modern services — especially finance. On the other hand, it is less enthusiastic about the digital economy. There are risks in making this distinction, however.

First, entrepreneurs in the favored sectors are well aware that the political winds could shift against them — the crackdown on the digital economy was swift and without warning. Second, even if policy can neatly discriminate between industries, in the real world the interlinkages are highly complex. Manufactured products, favored by the leadership, have ever more digital content both because the products themselves are increasingly “smart” and because complex value chains use digital services to manage production and distribution. So reining in the digital economy may have the indirect effect of hurting manufacturing as well.

China’s Complex Trade Picture

Before the pandemic hit, trade had been playing a smaller and smaller role in China’s growth, but that changed with the arrival of Covid-19. Exports and imports both increased 30 percent in 2021. And despite the fact that the U.S. has maintained 25 percent tariffs on about half of what we import from China, China’s exports to the U.S. increased 28 percent. The bilateral trade imbalance hit a new record of $397 billion.

The trade surge can be explained to a large extent by the differing responses of major economies to the pandemic. The U.S., in particular (and Europe as well), used government stimulus to sustain household income while people stayed home. China’s stimulus, on the other hand, focused more on getting production back online. Simply put, American and European demand met Chinese supply.

Working from home and entertaining themselves at home, Americans’ demand shifted from services to goods. People ordered laptops, smartphones, TVs, furniture, exercise equipment — exactly the sort of manufactures in which China specializes. The surge in demand strained supply chains for many products, while the sheer volume of trade put stress on U.S. logistics. In addition, ongoing Covid-19 outbreaks affected the operation of ports, trucking and warehousing. Despite these glitches, overall trade held up well, handling record volumes.

The U.S.-China trade took place under the aegis of the Phase 1 deal that the Trump administration negotiated with China early in 2020. The heart of the agreement was a commitment from the Chinese government to increase specific imports from the U.S. totaling $200 billion (compared to 2017 levels) during 2020 and 2021.

The agreement was widely criticized by economists at the time of signing because it amounted to a kind of managed trade rather than an opening of the Chinese economy. Furthermore, the target was unrealistic, as it would have required increases of U.S. exports to China of more than 40 percent annually. The 25 percent tariff was also left in place, a burden that is largely paid for by American firms and households.

What was the impact of the Phase 1 deal? First, U.S. imports from China continued at a heady pace, showcasing American demand for Chinese goods even with a 25 percent tax in place. Second, U.S. exports to China have grown at a healthy rate, reaching an historic high in 2021. Still, China fell far short of the purchase commitments. There were a few areas, such as soybeans, where the actual trade was close to the target. But managed trade typically fails to meet its objective because governments cannot anticipate the vicissitudes of demand.

The Biden administration now faces a difficult situation with China trade. As noted, U.S. exports have hit a record high, with a variety of sectors of the U.S. economy prospering by selling to China. To re-ignite the trade war in this environment would be bad for the U.S. economy.

On the other hand, China did not meet the targets in the Phase 1 deal, and Biden is likely to be criticized as soft on China if he gives them a pass. Meanwhile, the continuing 25 percent import tariffs on the U.S. side are distorting demand and contributing to inflation.

The Ukraine war provides new potential for U.S.-China trade tension. China is supporting Russia rhetorically, but as this is being written in April, its banks and enterprises appear to be honoring Western sanctions. If China does fail to conform, it is likely to lead to further decoupling between the world’s two largest economies.

While the overall volume of trade for China was impressive during 2021, there were some subtle shifts in trade patterns that may portend major changes. First, what did not occur was any significant re-shoring of production to the U.S. To the contrary, the U.S. imported more than ever before. And while U.S. imports from China were surprisingly robust, U.S. imports grew even faster from other countries, notably Vietnam.

Indeed, some labor-intensive assembly has shifted from China to Southeast and South Asia. This is largely driven by economics, as wages have gone up in China. But politics is no doubt a factor as well. Assembly outside China enables producers to get around U.S. import tariffs. And given the potential for the U.S.-China trade war to re-escalate at any time, shifting some production from China to elsewhere in Asia seems a smart hedge. From China’s point of view, the U.S. has become a less important market: the Association of Southeast Asian Nations, or ASEAN, nations are now collectively China’s largest trade partner, with the EU in the second spot.

These shifts are likely to be reinforced by new trade agreements. Most important is the Regional Comprehensive Economic Partnership (RCEP) among ASEAN countries (Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam), China, Japan, South Korea, Australia and New Zealand. RCEP ends tariffs on more than 90 percent of goods and offers preferential market access for specific products (including chemicals, plastics and processed foods), as well as streamlines customs procedures that will, among other things, guarantee express items such as perishable food are released within six hours.

RCEP, moreover, establishes simple rules of origin that should solidify Asia’s position at the heart of most supply chains. The larger economies in this grouping also tend to be members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), which China and South Korea are now applying to join. China’s membership could take some time to work out. But it is likely that the world’s largest economy (in terms of purchasing power) will ultimately join, and that this deeper agreement will be the foundation for future trade rules in the Asia-Pacific region. Meanwhile, the U.S. is missing in action from Asia-Pacific trade deals.

What Next?

Prospects for China’s economy are mixed. On the plus side, it still has a lot of catch-up potential in terms of productivity, a high savings rate to fund investment and trade agreements, such as RCEP, that should provide better access to nearby economies. True economic convergence can only take place among open economies, so it is important that China continue to open its economy to foreign trade and investment.

On the negative side, China’s demographics guarantee the total labor force will continue to shrink, which is a difficult environment for economic growth. While capital is abundant, the way it’s allocated is quite inefficient. Correcting this would require a shift away from state ownership toward the private sector — a shift that is unpalatable for the current leadership. Instead of channeling resources to the private sector, Beijing has been cracking down.

A final wild card is U.S.-China relations. While the status quo is acceptable, an escalation of the trade war would create an additional drag on China’s economic growth.

China is unlikely to take all of the measures it needs to address its growth headwinds, given that many of them will be met with considerable political resistance since they involve shifts from state control to allocation via market forces. Still, China is likely to do enough to grow at a medium pace for the next one to two decades — and it only needs to grow at 4 percent to surpass the U.S. as the largest economy in nominal currency terms by about 2035.

I would be very surprised if China cannot manage that.