The way I view the prospects of the Chinese economy in the coming years is with guarded optimism – guarded because distortions are rampant in the economy, from the vast misallocation of resources to the highly distortionary macroeconomic structure that propels a vicious cycle – but optimistic, for exactly the same reason. The existence of important and pervasive distortions mean that there is still room for growth. The larger the misallocation, the greater the potential for efficiency gains.

China is different from other countries because it has a highly distorted economy. Central planning in the past left many distortions in place, still waiting to be removed one by one through bouts of individual reforms. Thus, unlike many emerging economies today, and unlike the East Asian Tigers of the past, China has a far more power development tool: reforms. Reforms which reduce distortions, reallocate existing resources to its most productive use, will stimulate productivity growth – inherently much more sustainable than capital accumulation.

In the past, the large reallocation of labour from low-productivity to high-productivity areas has been an important source of growth. First, starting from the late 1970s, it was labour reallocating out of agrarian sectors to manufacturing sectors. Then, in the 1900s, labour moved from low-productivity state sectors to private sectors, unleashing another wave of growth. The next wave of growth will come from reallocating capital towards its most productive use.

To date, capital markets are the most distorted part of the economy. Private sectors, especially small and medium-sized firms, are thirsty for capital. The reallocation of capital away from state-owned companies that absorb a disproportionate amount of national investment towards its more efficient use for more productive private firms can create the next big wave of growth spurt in China. But the critical ingredient is reform.

Another reason to be optimistic is that labour productivity growth is high and human capital is accumulating at a rapid speed. While China has traditionally been a country that emphasizes education and executes reasonable meritocracy, the one-child policy itself has accelerated the accumulation of human capital. In research with my “The One-child Policy and Household Saving Puzzle”co-authors Taha Choukhmane and Nicolas Coeurdacier, we find that an only child receives substantially more education investment than a twin (born under the one-child policy); almost twice as much when it comes to discretionary education for a child between 15 and 21.

The reason is simple: there is a quantity-quality trade-off at work. Most urban families had only one child in the 1980s and 1990s, and could afford to invest significantly more in the child’s education. Education investment translates directly into school attainment; twins are 40% more likely enrol in a technical/vocational high school rather than an academic high school compared to an only child. This means, quite simply, that we have a super generation of highly educated, but potentially psychologically stressed, only children.

Yet, high human capital and a massive injection of skilled labour and college graduates into the economy do not translate into the actual creation of employment. China’s current and future problem is the opposite of the US’s. While there is a growing demand for skill labour but a slowing rate of supply, the opposite is true in China. China’s addition of as many as 7 million college graduates every year has lead to many young people without jobs.

Employment generation is a general problem in the Chinese economy. Over a rapid period of growth, the employment growth has only been about 1% on average every year. What is the reason behind this low creation of jobs? A key factor is that the economy is overweighted towards manufacturing sectors. These sectors see the highest growth in labour productivity and a low growth in actual employment. In contrast, service sectors have relatively low labour productivity and high employment growth. To generate employment, the Chinese economy needs to restructure away from manufacturing and secondary industries to service sectors.

But pumping up the manufacturing sectors perhaps goes back to a historical mentality and bias of placing excessive value on production; more production and then exports. Higher production than the capacity to absorb it domestically invariably leads to a large trade surplus, but this is a problem greater than just a currency misalignment, which would do little to help correct the global imbalances.

And yet these signs of concern – low employment growth, weak consumption, environmental issues, short-term growth slow-downs, large external imbalances – are all symptoms of the same problem: the highly contorted macroeconomic structure that sustains a vicious cycle. In this cycle, financial repression and wage suppression subsidize exports and production. Low labour and capital income weakens household demand, suppresses the households, and therefore the government is compelled to rely ever more on exports and investment to maintain GDP growth. This, in turn, requires further distortionary subsidies that appropriate resources away from households. And so on and so forth.

Though seemingly disparate, some of China’s most controversial policies – capital controls, fixed and undervalued exchange rates, managed interest rates, financial repression and wage suppression – work together to weave a web of distortionary policies, interlinked, independent and symbiotic. This complex web thrusts the economy into a contorted cycle: the deeper it plunges, the more difficult it is to get out.

Thus, it is fair to say that where there is weakness in China’s economy, there is also opportunity for sustained growth. Simply correcting the misallocation of existing resources, especially in capital, can unleash more growth than one can imagine. But whether this happens or not, and how long it would take, all depends on how successfully and swiftly reforms are implemented.

One can still be reasonably positive that the one-child generation, once becoming the key agents in the economy in a few years’ time, would boost productivity. But none of these advantages would come into full realization unless the government’s mentality and bias towards a production-based economy undergoes some pretty dramatic changes.

This is part of a series of posts marking the 10-year jubilee of the World Economic Forum’s community of Young Global Leaders.

Author: Jin Keyu is Assistant Professor of Economics at the London School of Economics and Political Science and a World Economic Forum Young Global Leader.  

Image: People walk past a lantern decorated with a dragon pattern ahead of the Lantern Festival at Yu Yuan Garden in downtown Shanghai February 5, 2012. REUTERS/Carlos Barria