by Mark Purdy  |   10:00 AM November 29, 2013

China’s economy has entered a critical phase. Since the country opened its doors in 1978, the economy has witnessed tremendous growth. Its gross domestic product has surged from less than $150 billion in 1978 to $8,227 billion in 2012 (see “China’s GDP” chart below). In the process, more than 600 million people have escaped poverty. This is a marvelous achievement for any country, let alone one as geographically large and populous as China.

China’s business landscape has also undergone a transformation. It boasts 85 companies in the Global Fortune 500 list of the world’s largest corporations. Foreign investors have flocked to the country’s shores as many of the world’s largest manufacturers have established operations there. Many iconic brands dot the shopping districts of the major cities. Despite these impressive achievements, there is still plenty of room for catch up, with China’s per capita GDP only a fifth of the U.S. level (see “GDP Per Capita” chart below).

China’s growth has come largely from a rising labor supply and rapid capital accumulation. While these factors will remain important, in the next decade China must put greater reliance on productivity growth — the ability to get greater output from existing labor and capital stocks. The government has emphasized the need to rebalance growth, focusing on raising domestic consumption and living standards. However, transitioning to a more economy, while maintaining current growth rates, will not be easy.

Decomposing China’s GDP growth over the last three decades, we assessed the drivers behind it such as labor, capital, and total factor productivity (TFP), which is a more precise measure of efficiency in the use of inputs other than labor and capital. As shown in the chart “China’s Sources of Growth” below, capital has been the key driver of China’s growth over the last three decades. Capital accumulation accounted for 6.9 percentage points of the 10.5 percent average annual increase in GDP in the last decade, 5.7 percentage points of the 10.1 percent average annual increase in GDP in 1990 to 2002, and 7.2 percentage points of the 9.7 percent average annual increase in GDP in 1979 to 1989.

Meanwhile, the contribution of labor to GDP growth is decreasing. It contributed 1.4 percentage points of GDP growth in 1979-1989, 0.5 percentage points in 1990-2002, and 0.3 percentage points in 2003-2012. Because of the one-child policy, China’s population growth is slowing. Moreover, the population is aging and the size of the labor force is set to plateau in 2016 (See “China’s Labor Market” chart below). A shrinking labor force will be a drag on growth. In fact, China is already experiencing a labor shortage: Wages are rising and it is losing its labor-cost advantage to other developing countries.

During the last decade, China relied increasingly on investment to boost its economy. This was obvious during the financial crisis in 2008, when the government invested about 4 trillion RMB to enhance growth. Such investments might not be sustainable in the long term. Policy makers and scholars generally agree that China must rebalance its economy toward a consumption-driven development model. This is the overarching goal of China’s 2010-2015 plan.

China will find it hard to sustain rapid rates of economic growth in the future. Our research suggests that if China wants to lower the investment ratio to below 40% of GDP by the end of next decade, while keeping the rate of economic growth above 8 percent (essential for maintaining full employment), it must improve the growth rate of productivity. In the most optimistic scenario, where GDP growth during the next decade is sustained at the same rate as during the last decade (10.5%), annual productivity growth would need to jump from 3.3% to 5.6% (See the “How Much Productivity Is Needed to Drive Future Growth?” chart below).

Since China opened up, the nation has travelled through different stages of development. As the impact of the labor bonanza and capital-led phases begins to fade, productivity growth in China must increasingly come from the quality of innovation and management expertise at the organizational level. Witness the rapid growth in US productivity levels in the 1990s and 2000s in sectors such as retailing. That growth was driven largely by the increased use of information technology in customer analysis and supply chain optimization.

China, too, needs more technological innovation. China has almost tripled the share of its GDP devoted to R&D over the past 20 years, from 0.65% in 1993 to 1.97% in 2012 (See the “R&D Expenditure in China” chart below.) although it still remains below that of the US. This is attributable to China’s national technology strategy of “market access in exchange for technology.” The strategy stems from China’s desire to acquire new technology through technology transfer or foreign direct investment, and assimilate it through learning, imitation and other means. The ultimate goal is the ability to innovate independently. Chinese firms have realized that they cannot just purchase core technologies; they must create them on their own.

Franz Kafka once said that productivity is about being able to do things that you were never able to do before. By addressing the productivity imperative now, China, too, can continue doing things it has never done before.