http://www.economist.com/businessfinance/economicsfocus/displaystory.cfm?story_id=14844987

Economics focus

Secret sauce

Nov 12th 2009
From The Economist print edition

China’s rapid growth is due not just to heavy investment, but also to the world’s fastest productivity gains

PRODUCTIVITY growth is perhaps the single most important gauge of an economy’s health. Nothing matters more for long-term living standards than improvements in the efficiency with which an economy combines capital and labour. Unfortunately, productivity growth is itself often inefficiently measured. Most analysts focus on labour productivity, which is usually calculated by dividing total output by the number of workers, or the number of hours worked. According to new figures published on November 5th, America’s output per hour worked has increased by 4.3% over the past year, thanks to big job cuts. Even more impressive is China, where labour productivity has risen by 7-8%.

The snag is that labour productivity is an incomplete gauge of efficiency. Firms can boost output per man-hour by investing more and equipping workers with better machinery. But once the extra capital spending is taken into account there may be little or no gain in overall economic efficiency. Part of the jump in America’s labour productivity during the “new economy” era of the late 1990s reflected a rise in investment as a share of GDP. The huge increase in China’s labour productivity in recent years is partly due to heavy investment rather than true efficiency gains.

A better gauge of an economy’s use of resources is “total factor productivity” (TFP), which tries to assess the efficiency with which both capital and labour are used. Once a country’s labour force stops growing and an increasing capital stock causes the return on new investment to decline, TFP becomes the main source of future economic growth. Unfortunately TFP is much harder to measure than labour productivity. It is calculated as the percentage increase in output that is not accounted for by changes in the volume of inputs of capital and labour. So if the capital stock and the workforce both rise by 2% and output rises by 3%, TFP goes up by 1%. Measuring hours worked is fairly easy, but different ways of valuing a country’s capital stock can produce different results.

The OECD publishes figures for its rich-country members. These show that since 1990, average TFP growth has been remarkably similar in America, Japan, Germany, Britain and France, at around 1% a year. A recent report by Andrew Cates, an economist at UBS, attempts to estimate TFP growth in emerging economies over the past two decades (see chart). He calculates that China has had by far the fastest annual rate of TFP growth, at around 4%. Probably no other country in history has enjoyed such rapid efficiency gains. India and other Asian emerging economies have also enjoyed faster productivity growth than other developing or developed regions. In contrast, productivity in Brazil and Russia has risen more slowly than in rich economies.

These figures undermine a common claim—that China’s rapid growth has been based solely on overinvestment. Sceptics like to compare China with the Soviet Union, where heavy investment also produced rapid rates of growth for many years before it collapsed. But the big difference is that TFP in the Soviet Union actually fell by an annual average of 1% over 30 years to 1988. In contrast China’s productivity has been lifted by a massive expansion of private enterprise, and a shift of labour out of agricultural work and into more productive jobs in industry. China’s average return on physical capital is now well above the global average, according to Goldman Sachs. A decade ago it was less than half the world average.

Why have the Asian economies led the pack? The most important determinants of longer-term productivity growth are the rate of adoption of existing and new technologies, the pace of domestic scientific innovation and changes in the organisation of production. These, in turn, depend on factors such as the openness of an economy to foreign direct investment and trade, education and the flexibility of labour markets.

Using a composite index of technology penetration and innovation (including, for instance, computers and mobile phones per head), Mr Cates finds a strong link between the rate of increase in an economy’s technological progress and its productivity growth. China’s level of technology is still well behind that in America, but it has seen by far the fastest rate of improvement over the past decade. This is not just because China started from such a low base but also because it is more open to foreign investment than many other emerging economies, including Japan and South Korea when they were at similar stages of development. China’s TFP growth is almost twice as fast as that of Japan and South Korea during their periods of peak economic growth.

An emerging advantage

UBS’s analysis suggests that the financial health of firms and governments also matters for productivity growth. Although TFP measures the extra gain in economic efficiency after taking account of the direct impact of a larger capital stock, weak balance-sheets constrain the availability of capital for new technology and innovation. The financial crisis may therefore reduce TFP growth in many rich countries. Some analysts also worry that future productivity growth in emerging economies will be curbed by slower growth in world trade and capital flows. But Mr Cates argues that healthier domestic balance-sheets in most emerging economies, along with continued rapid adoption of old and new technologies, should support robust productivity gains. He thinks that China, India, Indonesia and Brazil look particularly well placed. China’s surge in infrastructure spending will also help.

That said, even if China’s productivity growth remains faster than that of the developed world, it is likely to slow unless the government pushes ahead with bolder reforms. China’s growth is still too capital-intensive. Opening up the service sector to private firms and making it easier for workers to shift from rural to urban areas would result in a better allocation of labour and capital. That would help sustain rapid growth but would also make it more job-intensive. The resulting fall in labour-productivity growth might cause alarm among some analysts, but TFP would remain strong.