China’s Innovation Boom Masks a Deepening Productivity Problem
Despite remarkable advancements in technology and manufacturing, China’s economic growth is increasingly hampered by stagnating and even declining productivity, raising concerns about the long-term sustainability of its state-driven economic model. As industrial policy gains traction globally, Beijing’s experience offers a cautionary tale: innovation alone is not enough to guarantee robust economic expansion.
Since assuming the presidency in 2013, Xi Jinping and the Chinese Communist Party (CCP) have prioritized achieving technological self-reliance through decades of long-term economic planning. “An array of state instruments have been deployed to drive the project,” explained a chief Asia economist at Capital Economics, detailing the use of grants, tax breaks, loan guarantees, and public procurement to support every stage of the supply chain, from raw materials to research and development. The scale of this intervention is substantial; data from the Global Trade Alert reveals that China has implemented over 7,500 subsidy policies since 2009 – roughly two-thirds of all such policies adopted by the G20 advanced economies combined, according to the International Monetary Fund.
These measures have demonstrably boosted Chinese innovation and industrial output. As previously outlined, China’s technological prowess has surged in recent years. Between 2003 and 2007, the nation led in just three of 64 critical technologies, but by 2019-2023, it had risen to the top in 57, according to the Australian Strategic Policy Institute. Today, China dominates the global market for electric vehicles, batteries, and renewable technologies, and is rapidly closing the gap with the United States in cutting-edge fields like biotechnology and quantum computing, as indicated by Harvard University’s Critical and Emerging Technologies index. The emergence of DeepSeek in January further underscored China’s growing expertise in artificial intelligence.
The country’s innovation ecosystem has also matured significantly. Chinese universities now produce more STEM PhDs than their American counterparts, and annual R&D spending has increased by over $480 billion (in purchasing power parity terms) since 2013 – exceeding that of the US. Crucially, Chinese firms are increasingly capable of exporting high-end products utilizing domestically developed technology.
However, this impressive manufacturing and innovation boom has not translated into corresponding gains in productivity. Xi Jinping’s focus on “high-quality development” centers on improving total factor productivity (TFP) – a measure of how efficiently labor and capital are combined. Yet, estimates from the IMF, Asian Development Bank, the Conference Board, and Penn World Table all suggest that China’s TFP growth has slowed since the late 2000s, with some indicators pointing to an outright decline in the late 2010s.
Analysis by the Lowy Institute reveals that China’s TFP growth has significantly underperformed that of East Asian “miracle” economies at comparable levels of development. Forecasters have also revised down China’s potential growth rate in recent years. “It takes time for innovation to boost growth, but this lag doesn’t explain why productivity has slowed so substantially or been weaker than other rich economies,” noted a Capital Economics analyst. “Something more structural is at play.” He added that the slowdown in productivity coincides with China’s increased focus on technological leadership following the global financial crisis.
While factors like China’s property market challenges, weak demand, and potential measurement issues may contribute to the problem, wasteful industrial policy is considered the primary culprit. An IMF working paper published in August estimated that industrial policy measures could have reduced China’s TFP by around 1.2 percent and its GDP by 2 percent. The sheer cost of these subsidies – approximately 4.4 percent of China’s GDP in 2023 – has fostered inefficiency, driven overcapacity, and resulted in substantial financial losses.
Subsidies have disproportionately benefited well-connected firms, rather than the most efficient ones, and have created barriers to entry for competitors, according to an emerging markets economist at Absolute Strategy Research. “Local officials tend to subsidise the same industries and then protect firms in their jurisdiction from competition,” he explained. “The reallocation of credit to high-tech manufacturing should, in theory, boost TFP. But it has been more than offset, in practice, by the misallocation of labor and capital due to duplicative local subsidies and suppressed market exits.” This interventionism also stifles productivity-enhancing opportunities, including start-up growth, as private venture capital finance has diminished due to government support. Further analysis suggests that state subsidies may incentivize companies to pursue low-risk projects to secure funding.
The rush to enter high-tech sectors and secure state support has led to overproduction and intense price competition, a phenomenon described as “involution.” Reports indicate that ports are overflowing with unsold electric vehicles and AI chips are accumulating in newly constructed, underutilized data centers. Exporting this surplus is becoming increasingly difficult as trading partners recognize the risk of dumping.
Despite these inefficiencies, Beijing’s industrial policy has successfully fostered output in strategic sectors, nurtured entire industries like shipbuilding and chipmaking, and created national champions such as EV maker BYD. However, this success has come at a significant cost. For every BYD, numerous firms incur losses and ultimately fail. The share of lossmaking Chinese manufacturing companies has risen steadily since 2013, with over one-quarter of listed non-financial firms having an earnings before interest and tax-to-interest coverage ratio below 1 in 2023, up from around 10 percent in 2018.
“Essentially, China has pivoted from one kind of inefficient over-investment in real estate to another,” observed a lead economist at the Lowy Institute. “Sure, industry and tech is more productive, but inefficiency, poor allocation of funds and excess investment has still sapped productivity in aggregate.”
In this way, China’s technological rise is both impressive and profoundly wasteful, forging highly productive technological titans alongside a multitude of struggling “zombie” companies. This serves as a warning to those who admire Xi’s model. Beijing’s successes are unique to its centralized structure, allowing the CCP to mobilize resources rapidly and focus on the goals of its industrial policy, often disregarding the means or consequences. “China has the wrong strategy for generating fast productivity growth,” the Lowy Institute economist noted. “A better one would involve liberalising markets, reforming state enterprises and strengthening rule of law.” Enduring growth and innovation require efficient utilization of capital, land, labor, public funds, and ingenuity – not simply shifting resources from one project to another. This necessitates both free market forces and prudent government oversight. After all, DeepSeek emerged from a hedge fund focused on algorithmic trading, not government subsidies.
Beijing can build tech giants, but it is far harder to manufacture productivity growth. The CCP should bear this in mind as it prepares to discuss its next five-year strategy at the Fourth Plenum in the coming days.
