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Launching a new global paradigm for inclusive and sustainable growth is only possible if China agrees to lead the way. Beijing has to commit to structural reforms to increase productivity while protecting the environment, public health and the population's overall wellbeing.

Aerial view: G20 Logo in field

One question will overshadow the G20 summit in Hangzhou like no other: Where will global growth come from? The G7 leaders already made that clear at their summit in Japan in May when they declared: “Global growth is our urgent priority.”

The days when the world’s leading industrialized countries were solely responsible for global growth are long over. They need the leaders of the emerging world on board, and this is why they should take their message to the G20 summit in Hangzhou. The future of global growth depends to a big part on the summit’s host country China.

The G20 have a bigger task than to repeat the G7 statement, which encourages growth generation through all available policy instruments – monetary, fiscal and structural. They have to take it one step further by defining the quality of future growth. China’s case shows that this can only be “smart growth.” 

China will have to transition from its traditional GDP growth model based on demand and output maximization to a “smart growth” model. Such a model would raise productivity and potential output through innovation while lowering resource use or keeping it at least constant. At the same time, it would minimize negative side effects for the environment and public health, contribute to overall human wellbeing and lead to a more just distribution of income and wealth.

Stunning decline of productivity in China

The decline of productivity is a global phenomenon, but it has reached the most acute stage in China. The Conference Board (TCB), a research group that measures drivers of economic growth, reports a substantial decline of annual labour productivity growth in China from 5.2 percent in 2014 to 3.3  percent in 2015, continuing a downward trend that started after 2006.

The other source of the problem is declining growth of all other productive factors beyond labour or capital, such as public health, education, and technological advances. Following TCB estimates, this so-called annual total factor productivity growth has declined at a stunning rate in China, from 4.4 percent between 1999 and 2006 to negative growth of -0.1 percent in 2014.

No other country has experienced such a steep decline, showing that China has to find ways to grow its production capacity beyond the expansion of labour and capital. More fiscal impulses and infrastructure spending will just mean throwing more money at the problem, rather than generating a foundation for a more sustainable growth model.

China’s economy faces four major impediments to smart growth. First, there is no price tag for environmental degradation. For decades, China’s economic players have not used natural resources in an efficient and sustainable way, and the ensuing pollution has endangered public health. In dealing with this issue, China still prefers regulatory measures over monetary incentives such as carbon taxes and/or emission trading. The balance should shift from a regulatory top-down approach towards “pay as you use” principles and transparency of environmental choices.

Reforming the tax and financial system

Second, China’s institutional framework has not kept up with the needs of a more productive workforce and a wealthier population. The social security net needs to be reformed to discourage excessive private savings and encourage responsible consumption, which is one of the seventeen Sustainable Development Goals as defined by the United Nations. China needs a progressive income tax system to meet its targets for income redistribution. The public sector needs to shrink, but remaining employees have to be better qualified and better paid, reducing incentives to generate illegal income through corruption.

Third, China needs to address the distortions in its financial system, which often rewards the wrong actors. Debt-ridden state-owned enterprises have easier access to financing than privately owned small and medium sized enterprises. A more efficient system would reward (private) innovators, rather than (government-owned) rent-seekers. Stricter enforcement of insolvency laws is also necessary to force unprofitable businesses out of the market.

Finally, China’s rise to a higher middle-income country that relies more on service production than on goods production requires more human capital formation below the middle-income group. This group has the largest untapped potential for smart growth, but it will take time and a large amount of financial resources to unlock this potential.

No fast and easy solutions

Taken together, all four factors would add to more inclusive and sustainable growth in China. Yet, there is no fast and easy way to smart growth. Losers are powerful and means of compensating them are limited. This holds true for China as well as for the other G20 countries.

This is why the leaders in Hangzhou will be tempted to equate smart growth with traditional GDP growth driven mainly by fiscal impulses, physical investment and cheap money. Launching a new global paradigm for future growth, which puts the population’s wellbeing at the centre – will only be possible if China leads the way towards this overdue course correction.