China's Economy: Where Do We Go from Here?

China's structural reform needs to be accompanied by traditional economic stimulus measures in a time of economic slowdown,according to Yao Yang,head of the National School of Development at Peking University. The following article focuses on the key problems of the economy and offers suggestions for solutions. It was excerpted and translated from an address given to the university's Executive Master of Business Administration New Policy Session 2017 in October.

Today,I would like to share some of my views on the problems faced by China's economy and offer some suggestions for future policies. First,cyclical factors may explain the slowing economic growth rate. The slowdown was wrongly interpreted as a result of structural problems,and the attempt to deal with these structural problems through reform has led to much dissatisfaction. We need to re-examine several conclusions reached on China's economy,particularly on the problems of efficiency,structural reforms and maintaining economic growth. We also need to look at debt levels and the high degree of leverage in the economy.

First,let's take a look at China's debt levels. Why is there so much money sloshing around in the economy? Where is the debt concentrated and how do we reduce this high degree of leverage?

I don't deny that structural problems have contributed to the slowdown. But the key is the global financial crisis which has forced China to reexamine its export-oriented developmental strategy.

We can compare China's situation to that of Japan in past years. Japan was also a fast-growing,export-oriented economy from the 1950s to the 1970s. After the 1973 oil crisis,it slowed down,with the average growth rate falling from 9.2% over the two decades prior to the crisis to 3.5% for the two decades afterwards.

China's average per capita income is around that of Japan's in the 1970s and some economists contend we face adjustments similar to Japan's. Some people suggest that China's economic growth rate could fall to about 3.5% a year,repeating the pattern seen in Japan.

We are pursuing a policy of creating jobs and encouraging innovation,and it is important for us to continue in this direction. But it doesn't mean this will allow us to maintain growth of more than 6.5%.

When Japan was in its fast-growth phase in the 1970s and 1980s,one American academic (Ezra Vogel) a specialist on China and Japan,wrote a book called Japan as No.1. This book was very influential at the time but then Japan's growth slid to 3.5% and people had to reconsider their conclusions. Technology alone cannot drive high levels of economic growth.

Another structural problem is that China is undergoing a de-industrialization of its economy.

Before 2010,industrial employment grew quickly and it eventually accounted for 30% of all jobs. This eventually stabilized,with employment from the service industry growing faster and accounting for over 55% of GDP. However,productivity in the service sector didn't grow as fast as that of the industrial sector,which led to a slowing of total economic growth. This is a key reason for the slowing of China's economy.

Every economy responds to its own economic cycle. China has experienced two big cycles since 1992 and four small cycles. From 1992 to 1997,China's economy was on an upward trend; and from 1998 to 2003 it was on a slowing path. From 2004 to 2012,it was moving upward again and from 2013 until now,it has been slowing once more.

Some Misunderstandings

Mainstream economists in China have claimed that low efficiency is the root of China's economic slowdown. They have provided evidence showing that the efficiency of China's economy was declining,and they use that to make their point. If we addressed institutional issues to improve efficiency,however,that would be putting the cart before the horse. How would China's economists measure that efficiency? The main measurement they used was called total factor productivity. According to Robert Solow's residual calculations,it is economic growth rate minus the weighted average of growth rates of capital and labor (the weightings are the respective proportions of returns on capital and labor as a proportion of GDP). Total factor productivity in fact is a black box with no one knowing exactly what is inside.

There are other ways to measure efficiency,and they are related to total factor productivity. The residual difference corresponds closely to the economic cycle. The TFP growth rate is high when capital and labor are fully deployed during economic expansion while the TFP growth rate is low when capital and labor are idle during periods of slower economic growth.

China's economic efficiency has been declining since 2005 because of a slower economic growth rate. It is clear that slower economic growth is the cause while the so called efficiency decline is the result. Therefore,it is wrong for economists to conclude that lower efficiency is responsible for the decline in China's economic growth.

Research and Development

Total factor productivity also reflects technological progress from the perspective of investment -- progress in research and development and human capital. Progress in developing human capital has been rapid due to better education. Every 10 years we find education expands by an average of a year so the return on education for younger people is much greater than for those people who were educated before them. The quality of education for people educated now is far better with a greater return than in the past..

Another focus is investment in research and development. Our weak knowledge base has led to very limited investment in research and development. The proportion of investment in research and development to GDP was 2.1% with an annual growth rate of around 0.1 percentage point. This was equal to 70 trillion yuan for the economy as a whole.

In the US,investment in research and development is equal to 2.7% of GDP,while it is slightly higher in Japan and South Korea. But China's 2.1% was not that much below the levels of developed countries. China ranked second in terms of total volume while the US was first. By the end of China's 13th five-year plan in 2020,China's investment in research and development as a proportion of GDP will reach 2.5%. That will put it ahead of many developed countries.

Some economists maintain there is too much investment in poorly planned projects. The basis for economic growth theory is the Solow Growth Model,which has two stages -- one is the catch-up and surpass period and the second is to consolidate a lead.

In the catching up and surpassing stage,the growth rate of per capita income equals the TFP growth rate plus the per capita capital stock (revised for the rate of return on capital). During this stage,there is an increase in capital and that leads to higher income and more investment. But in the consolidation phase,the marginal return declines and eventually investment is no longer worthwhile. For example,in the U.S. and the Europe where the growth rate of per capita income equals that of TFP,if we depend solely on technology to boost income,annual growth is just about 2%.

According to the latest standard of the World Bank,calculated in terms of the purchasing power parity (PPP),the international poverty level is having daily per capita expenditures of US$1.90 or less. Based on China's own rural poverty-alleviation standard of per capita annual income of 2,300 yuan,there are still over 70 million people living in poverty. According to the old standard used by the World Bank,the international poverty standard was having US$1.25 in daily per capita expenditures,and that translates in