Morningstar Magazine - December 2017/January 2018 - 44

Strategies

While China's rapid technological catch-up has
proved a major boon to growth, it naturally leaves
less scope for productivity-enhancing copycat
behavior going forward. Increasingly, Chinese firms
will need to innovate, rather than imitate. And
innovating is a lot harder to do.
The Rural Labor Surplus Dries Up
Second, as China has urbanized and industrialized
at a pace possibly unprecedented in human history,
the scope for boosting productivity by moving
ever more farmers to factories or storefronts is now
more limited.
For countries in the early stages of economic
development, labor migration from farms
to factories tends to be a major driver of economic
growth. That's because workers in the industrial
and services sectors are far more productive than
agricultural workers. Based on official figures, the
typical Chinese factory worker is roughly 4.5 times
more productive than his farming counterpart.
Labor migration has been a key source of
productivity growth for China in the past few
decades. According to official statistics,
employment in industry and services has risen by
303 million people since 1990, while agricultural
employment contracted by 175 million (total
employment expanded 128 million). Over the same
interval, China's official urbanization rate rose
to 57% from 26%.
Having urbanized at a possibly unprecedented
pace, China's agricultural workforce is much
smaller than it once was. But how much smaller?
That's debatable. It's an important question
as we consider the scope for continued
productivity-enhancing labor migration. China's
National Bureau of Statistics estimates the
country's agricultural workforce at 215 million in
2016 (28% of the total workforce), down from 389
million in 1990 (60% of the total), which would
suggest China is a long way from exhausting labor
migration as a source of productivity growth.

Academic studies indicate far fewer farmers
remain.5 Based on these studies, it's possible
China's agricultural labor force might have slipped
to roughly 150 million, which would represent
19% of the country's 2016 workforce, well below
the 28% estimated by the National Bureau
of Statistics. Meanwhile, labor migration to urban
areas has slowed by half in the past several
years, and the population of migrant workers under
30 years old has been declining since 2008.
This isn't to say that Chinese farmers will stop
moving to cities, only that fewer will make the trip
in the years to come. That implies additional
downward pressure on productivity growth. It also
means decelerating urbanization.
Whereas moving farmers to factories and
storefronts involved both spatial (rural to urban)
and sectoral (agriculture to industry and services)
reallocations, future changes to China's labor
mix will be mainly sectoral (industry to services).
This process has already begun. China's
industrial workforce peaked at 232 million in 2012
and slipped to 224 million by 2016. Over the
same interval, service-sector employment rose
from 278 million to 338 million.
The reallocation of labor from industry to services
will generate far less productivity growth than the
shift out of agriculture. That's because, according
to the World Bank, the "productivity differences
between industry and services are not as high as
those between agriculture and industry."6
High-Return Projects Will Get Even Harder to Find
Third, decades of rapid capital accumulation
have left China with far fewer high-return projects
than were available at the dawn of the reform era.
Despite enormous additions to the capital stock,
economywide returns on investment
remained impressively high for most of the reform
era. This was partly due to decades of economic
mismanagement under Mao, which left China

with a paltry capital stock and an ample array of
promising investment opportunities. More
important, however, were continued reforms that
boosted returns and improved capital allocation.
Since 2008, however, returns have faltered due
to repeated stimulus and stalled reforms. China's
total capital-output ratio, which measures
how efficiently the country's total capital stock
is being put to use, has deteriorated amid
overinvestment across vast swaths of the economy.
China's incremental capital-output ratio, which
measures how efficiently new capital is being used,
looks even worse. China generates 50% less
GDP for each new unit of capital than it did in 2007.
Today's China can no longer rely on brute capital
accumulation as a major source of productivity
gains. If anything, maintaining the current level of
spending would likely reduce productivity
growth. Overinvestment and overborrowing are
direct consequences of China's political economy,
which prioritizes (and incentivizes) growth
at all costs and does not subject governmentlinked borrowers to market discipline.
These problems are structural and, as such, cannot
be solved with political discipline. Beijing's
frequent admonitions of reckless borrowing and
spending by provincial and local governments have
had little impact over the years. Nor are
administrative measures (for example, President
Xi Jinping's various "supply-side reforms,"
which include capacity reduction quotas, debt/
equity swaps, and hybrid ownership structures)
likely to have lasting consequences.
That's because until Beijing abandons overly
ambitious GDP growth targets, repeated stimulus
efforts are likely. And until local governments
and state-owned enterprises face hard budget
constraints, they will be able to borrow
and invest to meet those growth targets. Barring
true structural change, returns on capital will

5 See Brandt, L., Hsieh, C., & Zhu, X. 2008. "Growth and Structural Transformation in China," China's Great Economic Transformation (Cambridge University Press); Cai, F. & Wang, M. 2008.
"A Counterfactual Analysis on Unlimited Surplus Labor in Rural China," China & World Economy, Vol. 16, Issue 1, pp. 51-65; Dong, Q., Murakami, T., & Nakashima, Y. 2015. "The Recalculation of the
Agricultural Labor Forces in China," July.
6 World Bank and the Development Research Center of the State Council, the People's Republic of China. 2014. Urban China: Toward Efficient, Inclusive, and Sustainable Urbanization, World Bank.

Morningstar December/January 2018

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