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China slips towards middle-income trap as reforms fail

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Chinese productivity growth has gone into reverse for the first time since the Cultural Revolution tore the country apart in the 1970s, according to a new study, highlighting the failure of recent reforms to set China on a sustainable development path.

That means that despite dramatic rises in the cost of labor, energy, credit and property, the average Chinese company has actually been getting less bang for its buck since the global financial crisis - a classic sign of the "middle income trap" that many other emerging economies such as Brazil or Malaysia have found themselves stuck in after promising starts.

"The findings strongly suggest that the over-building, the over-capacity and the 'advance' of the less efficient state into private sector markets have increasingly dragged on China's growth," wrote the report's author, Harry Wu, senior advisor at the Conference Board China Center for Economics and Business.

China's economic growth has relied increasingly on state-directed investment since the 2008/09 crisis. At the same time, the incremental approach preferred by Beijing to rationalizing state industrial giants and the financial markets they rely on has failed to bring sweeping change.

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The Conference Board research paper shared with Reuters uses new methodology to analyse China's Total Factor Productivity (TFP), a broad measure of an economy's long-term dynamism that tests how much product a country is getting out of all its various factor inputs, such as labor and capital, in aggregate.

The study argues that previous estimates of China's TFP growth have overstated past performance - including exaggerating GDP growth - and that, in the period following the financial crisis, China's actual TFP growth turned negative, dropping from an average of 3.3 percent from 2001-2007 to -0.9 percent from 2007-2012.

The period marked the first time productivity had been a drag on growth since 1971-1977, a period during which China fell into chaos thanks to a power struggle within the Communist Party that pushed the country to the brink of civil war.

The Conference Board said it had seen no sign that any of the factors holding back productivity growth through 2012 have been ameliorated since.

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Other studies based on official data show a slowdown, if not a reversal. Zhu Haibin, an economist with J.P. Morgan in Hong Kong, argued in a research note on Wednesday, using a different set of measures, that Chinese productivity growth had eased.

"Strikingly, the decline in potential growth appears to be driven primarily by a smaller contribution of total factor productivity, from 3.2 percentage-points in 2008 to 1.1 percent-points in 2013," he wrote.

Labor problems

Economists say that the advantages that propelled China's double-digit growth rates of the last decade have largely faded, and policymakers have publicly agreed.

For example, the real monthly wage of Chinese workers reached $495 (298.41 pounds) in 2011, significantly higher than their counterparts in the Philippines, Indonesia and India, according to an Accenture report.

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Previous academic studies have also highlighted the tendency of Chinese firms to depend on under priced credit and fixed asset investment to grow.

The problem is that economic growth naturally lifts wages, while at the same time rates of return on fixed-asset investment naturally decline, meaning it takes more and more investment to generate the same amount of growth, even as rising costs pressure profit margins.

The critical point at which a country must abandon the easy growth boosts of investment and cheap labor in favor of pushing up productivity is commonly referred to as a "Lewis Turning Point", and only a few countries, such as South Korea and Japan, have successfully managed to pull off the transition.

Chinese average wages have risen steadily in the last five years, now standing at one fifth of average U.S. wage levels, up from 4 percent 10 years ago, according to Deutsche Bank economist Torsten Slok in New York.

China is committed to reforms: Expert
China is committed to reforms: Expert

That's still a big discount, but labor is only part of the total cost of a product, and economists warn that China's labor cost discount is almost completely offset by high costs for other inputs, in particular energy, which some estimate is four times more expensive in China than in the United States.

Rising Chinese labor costs have been aggravated by another major efficiency problem - the industrial over-capacity resulting from a 2009 stimulus package, in which China poured cheap credit into the system to maintain employment as exports tanked.

The intervention staved off a crisis, but many economists say it did long-term damage to competitiveness, especially since it appears to have fostered a culture in which domestic firms have relied on credit to stay in business, without otherwise improving cost structures or product appeal.

It also propped up some of the most inefficient employers in China, the state-owned enterprises (SOEs) that get far weaker returns on assets than private firms, and reversed a previous reform trend that saw policymakers pushing SOEs to exit markets and avoid dabbling in areas outside their core industries.

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"The more serious problem for the state is SOEs' deteriorating financial performance since 2008, a trend that has reversed many of the gains achieved in earlier years," wrote Andrew Batson at GaveCal Dragonomics in a research note.

"But the real problem is that what started as a cyclical downturn became a structural one: all indicators of SOE financial performance have stayed low since 2008."

Creative destruction

The poor performance of many SOEs has created a major headache for policy makers, who want to shed industrial over-capacity but are reluctant to risk the unemployment such "creative destruction" would entail.

For example, an employee in the human resources division of a major state-owned airline said that her firm had been told to acquire smaller, weaker performing airlines in the name of consolidation without laying off redundant workers.

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"If the executive at this poorly run airline was paying himself a really high salary, he got to keep his job and his salary when he came on board," she said, speaking on condition of anonymity. "If we had someone of equal rank inside our airline making less, we simply gave that person a raise."

Thus, in many cases, consolidation in the state sector has occurred mostly on paper without delivering efficiency gains.

At the same time, Beijing has had difficulty forcing local governments to actually close down redundant factories.

In August the Ministry of Industry and Information Technology had to issue an emergency decree ordering officials to halt the development of new cement and glass production capacity, even though those industries are already suffering from a glut.

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Beijing is aware of the challenge, and has moved in recent months to increase the tempo of reform, allowing private investment into SOEs, capping SOE pay, and liberalizing interest rates, but it is too soon to tell whether they will pay off.

"I don't feel that the real structural reform actually has started," said Wu of the Conference Board. "But the China model has been exhausted."