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China Grows Down

HONG KONG – For more than three decades, China’s GDP has grown by an average of more than 10% annually. But former Premier Wen Jiabao rightly described this impressive growth performance as “unstable, unbalanced, uncoordinated, and unsustainable,” highlighting the many economic, social, and environmental costs and challenges that have accompanied it. Now China must choose between the export-based, investment-driven growth model of the past and a new, more viable economic order.

Cheap credit and perverse incentives – such as promotions for officials who contribute most to GDP growth – have led to massive but redundant investment, which, in turn, has contributed to excess capacity in manufacturing and infrastructure. This model is not only inefficient; channeling government resources to support investment also undermines China’s social development.

Given this, China’s leaders have decided to stop using GDP growth as the primary criterion for evaluating officials’ performance. Indeed, the 12th Five-Year Plan, which extends until 2015, aims to shift China’s economy to a new, more sustainable growth model based on quality and innovation, and accepts that annual GDP growth will likely fall to 7% during the transition.

Most discussion of growth models nowadays is based on work by the Nobel laureate Robert Solow. For Solow, GDP growth is determined by the factor inputs of land, labor, and capital, together with the economy’s total factor productivity (TFP, or the change in output not accounted for by changes in the volume of inputs, but by factors like technological innovation and institutional reform).