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  • Distortions in the Balance Sheet Matter to China’s Growth
  • Michael Pettis (bio)

In his most recent book, Markets over Mao: The Rise of Private Business in China, Nicholas Lardy carefully compiles and analyzes an enormous amount of data to support his claim that China’s private sector, and not the state, has become by far the most important source of recent growth in Chinese productivity and employment. Between 2010 and 2012, Lardy argues, private sector firms produced between two-thirds and three-quarters of China’s GDP, far more than the state sector, even as they received a disproportionately low share of resources (pp. 139-41). [End Page 148]

While reviewers have praised this important book mainly for refuting conventional wisdom on the central role of China’s state capitalism, I think they overstate the novelty of Lardy’s argument, and in doing so perhaps understate the real value of the book. It is widely known that in spite of limited access to capital, China’s small and medium-sized enterprises are highly productive, often extraordinarily so. What is more, worries about the sustainability of the growth in Chinese debt are driven precisely by concerns that the systematic tendency of the public sector to misuse resources—capital, most importantly—has driven down profitability even as debt has risen steeply. That China’s private sector produces more with less is not a secret.

Rather than reshape our understanding of the relative contribution of China’s market and nonmarket sectors, Lardy’s real contribution is to document carefully the ways in which the main sources of growth in Chinese productivity and employment have evolved from the centralized decision-making process that was set up more than twenty years ago to provide much-needed infrastructure and manufacturing capacity to one today that includes a highly productive, market-oriented private sector. By describing and explaining this extraordinarily complex and poorly understood story, Lardy also suggests the key reforms on which President Xi Jinping and his administration must focus.

Economists who are confident that China will maintain rapid growth while successfully rebalancing its economy—including Lardy himself, who argued in an April 30 presentation that “China could grow at roughly 8% a year for another 5 or 10 years,” against consensus forecasts of 6%–7%1—will agree with Lardy that if China’s market sector managed to grow as rapidly as it did in spite of limited access to capital and other resources, simply by reversing these constraints Beijing can ensure rapid growth as China’s economy rebalances.

But here is the paradox. Those who expect growth to slow significantly, as I do, find Lardy’s work no less useful than do his peers in optimism. It is a testament to the objectivity of Lardy’s research that we too will praise the quality of his data and agree with much of his interpretation. We will argue, however, that it is precisely because Lardy correctly identifies the reforms required to maintain high growth that we expect growth rates to drop sharply.

Economists notoriously ignore history, but history nonetheless suggests that the many attempts among developing countries to impose similar [End Page 149] reforms have always proved far more difficult than anyone expected. Because redirecting the flow of resources necessarily undermines institutions that have long controlled access to these resources, in China as elsewhere, these institutions prevent reforms from being implemented quickly enough to avoid either much slower growth or a risky increase in the debt burden. Premier Wen Jiabao promised in 2007, after all, to rebalance the economy with similar reforms, and yet China’s imbalances deteriorated rapidly during the next five years just as Beijing began denouncing the nefarious role of “vested interests.”

There is a second set of constraints, however, that limit the positive impact of reform in ways I believe Lardy, and most economists, tend systematically to underestimate. While Markets over Mao carefully describes the operations of the Chinese economy—or, put differently, how China’s “assets” are managed—it largely ignores how China’s liability structure will affect growth.

This point is often contested, mainly because it is so poorly understood. Most economists assume that growth is primarily a...


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