China Caught In “High-Technology/Low-Productivity Trap”

Comparisons With Japan

Source: press reports Note: Personal services, wholesale/retail, and construction are estimates because they include workers in the informal sector. Personal services includes housekeepers, caregivers, nannies, ride-sharing, and food delivery services.

Sometimes it seems that not a month has gone by without some expert or institution putting out a report on how America’s great Asian rival has become the global leader in dozens of the technologies most vital for the future. Or how it is seizing dominant market share in this or that pivotal product. Or how America needs to change its ways before it gives away the commanding heights of the economy and suffers diminished global influence. And then there are the books talking about the possibilities of war.

Oh, did I forget to say I’m not talking about China today, but Japan a few decades ago? In 1989, Larry Summers, one of America’s foremost economists, wrote just a month before Japan entered the lost decades, “An Asian economic bloc with Japan at its apex ... is clearly in the making. This all raises the possibility that the majority of American people who now feel that Japan is a greater threat to the US than the Soviet Union are right.” And, yes, in 1991, The Coming War With Japan predicted the inevitability of war within two decades. I also recall a scientist specializing in superconductivity saying he’d get another $10,000 in grants for every mention of Japanese competition in his grant applications.

I’m not saying that China’s technological achievements are being hyped for ulterior motives. Nor am I predicting that China will suffer lost decades like Japan. But I am saying the economy has serious structural flaws. Moreover, as Japan’s history shows, dominance in important economic sectors does not ensure future growth, let alone global supremacy. China is caught in a “high-technology/low-productivity trap,” a term introduced in a 2020 report by two economists at the US International Trade Commission.

The ITC report explains the apparent paradox. On the one hand, China is indisputably gaining a leading role, sometimes even supremacy, in a variety of technologies and industrial sectors. There is no way to dismiss that. On the other hand, by all sorts of measures, its economy is a mess, something I’ve discussed here, here, here, and here. The ITC economists explained how both realities can co-exist.

This post is an overview. I will post future reports that go into more detail on each of the following issues.

Innovation Leadership Does Not Automatically Mean Economic Leadership

As I’ve argued before, technological innovation by itself does not create growth. What creates growth is companies transforming innovation into economic value.

The most-cited barometer of a country’s innovative capacity is the Global Innovation Index (GII). In 2013, China ranked 35th. By 2025, it had reached 10th, surpassing Germany, Japan, France, and Israel. Among other upper-middle-income countries, the next-highest was Malaysia, at 34^th. This is absolutely remarkable.

And yet, in a prescient 2020 comment, the ITC economists wrote, “Whether such innovation capacity will result in improved GDP growth performance…is uncertain as countries with higher ratings have not clearly demonstrated such improvements in performance. In fact, China’s own growth rate and productivity gains have been declining even as its GII rankings have risen.”

As poor countries become richer, improvement in GII scores is part of the recipe. However, once countries become rich, it’s not so simple. On the contrary, among the top twenty countries in 2025, there was no correlation between its GII ranking and its growth rate. It depends on how effectively its companies can exploit that innovation (see chart below).

Source: https://www.wipo.int/web-publications/global-innovation-index-2025/en/gii-2025-results.html

Superstar Sectors Are Tiny Share of China’s “Dual Economy”

Like Japan at its peak, China suffers from a “dual economy,” a hybrid of super-productive, export-oriented sectors that dazzle the world and an even larger mass of domestically oriented, low-productivity sectors that hamstring overall growth.

As with Japan, Western analysts focus mostly on the impressive parts of the economy because those are the ones impacting them. Among the big superstars are electric vehicles, solar energy, and batteries. Global demand for these products is growing exponentially, and China is beating everyone else in filling that demand. Yet only 1.5% of Chinese workers produce solar energy products and components. Only 0.7% work in making all autos and auto parts, not just EVs. And only 0.2% make batteries (see chart at the top).

Moreover, there’s a huge divide in the productivity (GDP per worker) among different sectors of the economy. Manufacturing has the highest efficiency, although there are big differences among subsectors. In 2024, factories employed 18% of all Chinese workers but produced 25% of GDP. By contrast, 22% of Chinese labored in farming, but they produced only 7% of GDP.

If we make an index of productivity with manufacturing as 100, we can see that farming, wholesale/retail trade, and construction are huge laggards. Yet, these sectors add up to almost half (45%) of all jobs (see chart below).

Source: Press reports Note: The numbers in parentheses show the share of the labor force working in each sector

Keep in mind that, as in other maturing economies, manufacturing’s share of the economy is falling. In China, it fell from 29% of nominal GDP in 2017 to 25% in 2024.

The Best And The Rest

While some Chinese companies in certain sectors have made remarkable technological achievements—e.g., solid-state batteries—these advances are not being diffused to typical companies in the same sector. In a previous post, I pointed out the same syndrome in Japan. Countries grow best when this diffusion takes place.

The top 10% of Chinese firms in 31 manufacturing sub-sectors more than doubled their Total Factor Productivity (TFP) between 1998 and 2007, an increase of about 115%. By contrast, the median firm increased TFP by about 85%, and the bottom 10% by about 75%. I suspect the gap between the best and the rest is much bigger in sectors outside of manufacturing. (TFP is the combined productivity of labor plus capital; I’ll discuss below why TFP is a better predictor of long-term growth than just labor productivity.)

Refusal To Cull the Zombies

Worse yet, as in Japan, huge numbers of zombie companies are being sustained on artificial life support. That denies resources of labor, capital, finance, and real estate from those who could use those resources better. That hurts growth.

Consider China’s auto sector. As I detailed in this post, alongside China’s world-beating companies like BYD or Geely and a dozen others, there are about 230 more. Almost 100 of them sell less than 10,000 units per year. As a result, China has the capacity to produce twice as many autos as it can sell at home or abroad. This has resulted in a price war that hurts the best companies. China has wasted a lot of investment on factories that create virtually no GDP. Such overcapacity is seen in many industries.

With every passing year, we see a rise in the share of firms in China that do not earn enough to pay their interest bill (see chart below). Economists at the Dallas Fed reported: “The zombie share in manufacturing has risen fairly rapidly from a low of 4 percent in 2020 to 11 percent in 2024. With a sustained decline in industrial profits, this share looks likely to continue growing. Yet, China’s services sector has a higher proportion of zombie firms, increasing over the past several years to 17 percent in 2024.” Services now comprise half of GDP.

Source: https://www.dallasfed.org/research/economics/2025/1223

Without the “destruction” side of creative destruction, you get less creation. But, of course, you need a social safety net to help workers in zombie firms transition to better companies. China is deficient here, one of the reasons it sustains zombies.

Stalled Entry Of New Firms

All economies benefit from the entry of new, more productive firms. This mainstream view is the basis of my book, The Contest for Japan’s Economic Future, which demonstrated that Japan was highly entrepreneurial during the high-growth era (1953-1973) and became less entrepreneurial from the mid-1970s onward.

China suffers from a similar syndrome. In the period up to 2007-2008, two-thirds of China’s remarkable growth of manufacturing TFP came from the entry of new companies. By contrast, the exit of inferior firms made a limited contribution to productivity.

Unfortunately, the entry of new firms and their share of factory jobs peaked around 2007 and then declined sharply through 2013. The job share fell from 25% in 2007 to 15% in 2013 in the digitally intensive sectors, and from 20% to 10% in the rest of manufacturing. The share has undoubtedly declined even further since then (see chart below). It’s no coincidence that, as the entry of new firms slowed, so did TFP growth, as I detail below.

Source: World Bank at https://bit.ly/EAP2024_FullReport Note: Top line is digitally-intensive sectors, and the bottom line is the rest of manufacturing

China Investing More Instead of Investing Better

Like Japan, China is trying to boost labor productivity by piling on more and more investment. But as economies mature, investment faces diminishing returns. I’ve seen with my own eyes how building modern roads replaces subsistence farming with farming for the market, thereby greatly improving farm productivity and farmer income. But, at some point, it takes far more dollars of road-building to gain each dollar of GDP growth. While giving workers more computers boosts their productivity, at some point, it helps even more to replace a 2010 computer with one made in 2026. China’s obsession with excessive levels of investment instead of diffusing this kind of technological upgrade is a main reason why its growth is decelerating so rapidly. Japan makes the same mistake.

TFP is the measurement that captures the benefits of such upgrades. It involves not just technology in the narrow sense, but how well firms use that innovation. Historically, China has typically had a lower level of TFP than other countries at the same level of per capita GDP. The light dots in the chart below show various countries’ levels of TFP relative to the US (indexed at 1.0). The red line shows China’s TFP relative to the US over the years as China’s grew. The rise in the ratio is the classic “catch-up” phenomenon. What’s troubling is that catch-up started to decline a decade or so ago.

Source: https://documents1.worldbank.org/curated/en/833871568732137448/pdf/Innovative-China-New-Drivers-of-Growth.pdf

From 1980—the beginning of Deng Xiaoping’s reform—through 2009, growth in GDP per worker accelerated to a stunning 9.3% per year, and a third of this leap came from growth in TFP. By contrast, in 2010-2019, labor productivity slowed to a still-stunning 7.2% even as China poured on even more investment. That’s because TFP contributed just 1.1 percentage points to growth instead of 3.1 points (see chart below).

Source: https://share.google/ail8eN9R2w6GeCvTY

TFP growth has gotten even worse, almost negligible, in 2023-24.

None So Blind As Those Who Will Not See

If China is in trouble, it is not because of a mythical “middle-income trap,” discussed in this post, but the result of decisions by Xi Jinping to reverse many of the policies that had created the Chinese miracle. Rather than face up to these flaws, Beijing has made it a violation of national security law to “defame” the economy.

One final note: even with these drawbacks, China’s economy is sufficient to support the country’s geopolitical challenges to the West unless it results in social dislocation.

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