Explaining Economic Growth and Savings Rates in China Following Its Demographic and Industrial Transformation

Since the end of the Cultural Revolution in 1976, China has altered its demographics and industrial structure while transitioning from a fully centrally planned economy to a mixed economic system that is part state owned and part market based. Its privatization of many state-owned firms and its one-child policy are two of the most dramatic policies affecting China’s society over the past several decades. In their paper, “Demographic Transition, Industrial Policies, and Chinese Economic Growth,” Philadelphia Fed economists Michael Dotsey and Wenli Li and Louisiana State University economics professor Fang Yang, study the impact of these government policies — including how these policies interacted by incentivizing households and firms — on China’s economic success since the late 1970s. In addition, the authors study how human capital investment affected output and savings rates.

The authors provide some interesting statistics that highlight China’s economic transformation.¹ Gross domestic product (GDP) per capita has grown extremely rapidly over the past few decades as the economy moved from being primarily agriculture based to largely manufacturing and service based. In the earlier days of China’s policy-driven transformation (1976 to 1980), GDP per capita grew under 5 percent annually, but its growth jumped to nearly 10 percent annually in the early 2000s. Since then, GDP growth has averaged around 7 to 8 percent per year. Aggregate savings (defined as household plus corporate savings) as a percentage of output increased from about 35 percent in the early 1980s to just over 50 percent at its peak in 2008, which is remarkably high by international standards. (Aggregate savings has hovered above 40 percent since then.)

Over this transformational period, China also experienced a substantial reduction in fertility and an impressive increase in life expectancy. As a result of the government’s demographic policies — including its one-child policy, which was in place from 1979 to 2015 — the birth rate fell from 1.8 children per adult in 1976 to 0.8 children per adult in 2015 (World Bank figures). Also, improvements in health care drove increases in life expectancy from a low of 57 years for a person age 23 in 1979 to a high of 75 years for the cohort of 23-year-olds in 2020.

At the same time, China’s industrial structure changed dramatically, with a marked shift in emphasis to nonagricultural sectors, along with a wave of privatizations. Employment in private companies rose from near zero in the early 1980s to over 60 percent of total employment by 2015. The government also strongly encouraged entrepreneurship by instituting its first patent law (permitting state-owned firms to go bankrupt and thus allowing them to be subject to the forces of competition) and by making the overall business environment conducive for private innovation. Moreover, since the late 1990s, credit policies favoring capital-intensive enterprises played an important role in increasing China’s capital accumulation. This credit policy left private enterprises, which operate in both capital- and labor-intensive industries (although mostly operating in the latter), to rely more on internal sources of financing.

The authors developed a unified framework to study the impact of demographic changes and industrial polices on the growth of the Chinese economy from 1976 to 2015. They considered both the household side and the firm side of the economy and how these two sides interacted to affect economic outcomes. On the household side, their model accounts for the lower fertility rate and increases in life expectancy as well as government policies that delayed the retirement age and reduced pensions. On the firm side, their model considers China’s industrial policies that promoted technological improvements, beneficial credit terms, lower financial mediation costs, and the growth of private firms. Their model also incorporates the significant investments in human capital made by parents on behalf of their school-age children and the transfer payments from adult children to their parents as part of their overlapping-generation framework.²

Their model results show that the government’s demographic and industrial policies by themselves contributed significantly to China’s impressive per capita output and savings rates (both household and business savings), although at varying times and to varying degrees.

The authors’ counterfactual exercises allowed them to isolate contributions to economic activity from specific demographic changes and government policies. For instance, the authors found that the lower fertility rate, longer life expectancy, and decrease in pensions led to sizable increases in household saving. These same demographic changes encouraged families to invest more in their children’s education; later on, parents benefited from transfer payments from their children.

They also show that government policies that helped to promote the growth of private firms in labor-intensive sectors led to increases in wages, educational investments, and savings by private firms. In contrast, government credit subsidies to the capital-intensive sector increased the demand for capital and raised the interest rate on household bank deposits. As a result, these subsidies encouraged household savings but discouraged human capital investment.

They further found that investments in human capital played a key role in the economy, explaining that these investments have been “a prominent part of the Chinese growth experience.” Specifically, human capital investments, which helped to create a more productive workforce, reduced household savings in the short run (before 2010) but increased GDP per capita in the medium-to-long run (after 2005).

Finally, Dotsey, Li, and Yang show that China’s industrial and demographic policies interacting together led to higher savings after the late 1980s and reduced economic growth after 2010. The authors suggest that when examining the causes of China’s rapid economic growth, “there are important reasons to consider these various avenues in tandem.”