China's Fragile Economy: A Story of Declining Productivity and Growing Debt

China's economy is fragile. Declining productivity and investment returns have led to slower growth and unsustainable increases in debt. The growth in debt, and economic growth, will eventually have to fall—either gradually via deleveraging or, less probably, suddenly via a financial crisis. In turn, slower growth could lead to economic and political stress domestically as well as weakness and instability internationally.

Why Is China's Debt Growing?

China's current debt problem is a consequence of the same growth model that has produced four decades of rapid growth. China has grown by both borrowing and investing at very high rates. Until 2009, this policy generated rapid growth in gross domestic product (GDP) and sustainable debt burdens; since 2009, however, it has led to slower growth and an increase in debt (see Figure 1). China's model has not changed; it has simply stopped working. The reason: falling productivity growth.

Wu and Liang estimate that growth in aggregate total factor productivity (TFP) contributed 1.32 percent to China's growth between 2001 and 2007, but TFP actually fell between 2007 and 2012, reducing growth by 1.42 percent.¹ In the latter period, China's average GDP growth was still over 9 percent, but this was only achieved through high levels of investment, which led to increasing capital growth to offset declining productivity (see Figure 2). China's investment as a share of GDP reached 48 percent in 2011, which is almost unprecedented for a large economy (for comparison, the US invests about 20 percent of GDP).²

Unproductive investment can boost GDP in the short run, but it is unsustainable in the long run. To see why, consider a simple example. If a firm borrows $100 at a 10 percent interest rate, it would need to repay $10 each year. If it invested that $100 in a productive project that earns a return of 15 percent, it would earn $15 each year. As a result, income increases, and debt can be repaid. When investment returns are sufficiently high, high borrowing and investment leads to high growth with sustainable debt levels. On a larger scale, this was how China grew so fast before 2009.

Figure 1.

Growing debt and slowing growth. Since 2009, lower investment returns have led to slower growth and increases in the debt to GDP ratio. Data sources: Bank for International Settlements, OECD.

Figure 2.

Sources of GDP growth. GDP growth can be decomposed into growth in inputs (capital and labor) and growth in productivity. Since 2007, GDP growth has been maintained only by investment in capital offsetting declining productivity. Data source: Harry X. Wu and David T. Liang, "Accounting for the Role of Information and Communication Technology in China's Productivity Growth," Research Institute of Economy, Trade, and Industry (RIETI) Discussion Paper Series 17-E-111. (2017).

If the investment is less productive and returns only 5 percent, the situation is different. The investment will earn $5 per year, which will not cover the $10 of interest that must be paid. Borrowing to invest when returns are low leads to slow growth and increases in debt. If a country continues to borrow and invest in this way, it will eventually experience a financial crisis.³ This is the source of China's current economic problems.

Why Have Returns Fallen?

Investment returns tend to fall over time—something known to economists as decreasing returns to investment. The most productive investments are made first and less productive investments are made later. In the 1980s, China lacked basic infrastructure, housing stock, manufacturing capacity, and much else, so many investment opportunities offered high returns. Today, China's infrastructure is more developed so there are fewer readily productive investment opportunities.

Take high-speed rail as an example. Building a line between Shanghai and Beijing will earn high returns because there are many people who want and can afford to travel on this line. However, this line can only be built once—the next line...