Is China's growth hollow?

China's economy grew 9.7 per cent year-on-year in the first quarter, reigniting the debate over whether it is rising too quickly. But the government should also be concerned about the composition of the growth.

Economic growth is made up of three things. Accumulating more capital and employing more workers means more things can be made. The third ingredient is more mysterious. Economists call it productivity, a catch-all term which covers things like technology and workers' level of education. It is critical for developing countries. They can import hi-tech machinery, for instance. The transfer of underemployed labour from rural to urban areas is another big productivity booster. As a result of doing these things, China's productivity growth has been good. From 1979-1995, it made up between one-third and one-half of each year's gross domestic product growth.

However, in new research, Hu Angang, an economist at Tsinghua University, and Zheng Jinghai, an economist at the University of Gothenburg in Sweden, found that productivity growth fell dramatically during 1995-2001, making up only 6 per cent of total GDP growth in this period. While productivity was rising by between 3.3 per cent and 4.6 per cent a year before 1995, it rose only between 0.3 per cent and 2.3 per cent a year from then until 2001.

This finding is worrying, for a number of reasons. First, as an economy like China's develops, the rate of rural-urban transfer slows, and this naturally has an impact on productivity growth; however, it should not hit as suddenly as this. Second, it could trigger a re-evaluation of reforms in the late 1990s. That period saw provincial protectionism being dismantled, increased levels of foreign investment, more commercial lending by banks, rising education standards, falling trade barriers and, probably most importantly, an explosion in private sector activity. All these things should have improved economic efficiency.

The two academics have identified a few things that appear to have gone wrong. First, capital became too cheap, causing excess investment and creating incentives for companies to use capital rather than labour. The government has thrown money at infrastructure projects since the mid-1990s in order to boost employment, but the returns on much of the investment are expected to be tiny. Second, disguised subsidies for leasing land and using energy have encouraged the misallocation of resources.

Most worrying, the data suggests things are getting worse. Last year, GDP growth was 9.1 per cent, but that was almost entirely accounted for by the accumulation of capital. Productivity grew at only minus 1.1 per cent to 1.1 per cent (the range is based on the margin of error).

The economists' work is controversial. Research by the International Monetary Fund, using a different statistical method, found nothing much to worry about. But, if the two academics' results stand academic scrutiny, what should the policy response be?

Many in government already appear to be aware of the importance of 'quality' growth. Beijing has already lowered the growth target for this year from 8 per cent to 7 per cent. Efforts are being made to assess the performance of local officials on more criteria than just the short-term growth they engender. Most importantly, the findings demand that interest rates be further reformed to better reflect the cost of capital, that subsidies and monopolies is broken down, and that the financial sector is reformed to allocate capital more efficiently.

China's economy can probably grow at 8-10 per cent a year without overheating. But if problems tomorrow are to be avoided, then the balance of that growth today has to be right.

Stephen Green is head of the Asia Programme at Chatham House in London and author of China's Stock Market Development, 1984-2002