China’s latest Five-Year Plan—the state’s primary policy blueprint—cements the country’s transition toward economic growth centered on productivity and social development. To achieve the latter, the central government has increasingly rewarded and promoted local leaders who maintain high employment rates in their respective jurisdictions, a practice better known as the cadre evaluation system. In their attempts to keep unemployment low, however, local leaders protect inefficient or unproductive firms, often with financial support like cheap credit. Ironically, in trying to promote social development, the cadre evaluation system has encouraged local leaders to sideline what is arguably China’s surest source of growth: productivity gains from the restructuring or closure of inefficient firms.
The cadre evaluation system encourages local elites to carry out central policy objectives, as it links their promotions and financial rewards to performance indicators established by senior officials in the Chinese Communist Party (CCP). Performance indicators have undergone significant changes over time. In the first two decades of post-Mao China, for example, local leaders were evaluated mostly on quantifiable, or “hard,” growth targets, such as the annual gross value of industrial output in their respective jurisdictions. This incentive structure backstopped domestic and foreign investment in physical capital, contributing to the rise in China’s GDP per capita of around six to eight percent each year. Such miraculous growth, however, soon worsened income inequality and unemployment. As popular discontent with the system swelled at the turn of the century, the CCP elite expanded cadre evaluation metrics to include social development indicators like urban employment.
While well-intentioned, this attempt to de-emphasize hard growth targets also meant that local leaders would score poorly for the layoffs that occur when huge firms downsize or exit the market. This adds another incentive to prop up inefficient firms with cheap credit and tax benefits. Hence, despite former premier Zhu Rongji’s landmark campaign to shutter inefficient state-owned enterprises (SOEs) in 1998, China is home to a large number of ‘zombie firms’—financially distressed companies that generate just enough cash to continue operating and service debt interests, but not enough to pay off the principal—many of which are privately-owned in industries like electric vehicles. Between 2018 and 2024, the share of all zombie firms in China nearly doubled from 6.3 percent to 12.2 percent, which is almost twice the global average for listed companies. While measures have been taken to restrict local governments’ discretion in giving out fiscal subsidies, other kinds of financial lifelines can still be provided to inefficient firms. Local governments can continue to offer tax benefits and loans at below-market interest rates, or in the case of Dayun Automobile Co., grant its trucks a highway toll exemption to boost its sales. These scenarios would likely occur so long as the fundamental incentive for local leaders to support inefficient firms remains unchanged.
Unfortunately, this aversion to letting inefficient firms exit also means China is missing out on significant productivity gains from doing so. This is unlike most advanced economies, where productivity gains from the restructuring or closure of inefficient firms have already been realized to a much greater extent. Economists estimate that such productivity improvements would raise China’s growth rate by 0.7 to 1.2 percentage points, nearly a fifth of the current GDP growth target of 4.5 to 5 percent. The downsizing or dissolution of inefficient firms would mean that large amounts of credit get redirected to more efficient firms. After all, Chinese zombie firms have long “competed” for credit with their more productive counterparts, lowering the latter’s total investment by two to eight percentage points. Rerouting credit to more productive firms would allow them to expand and constitute a larger proportion of the market, which would eventually raise the average productivity of the sector. Furthermore, the departure of inefficient firms would result in less crowded markets and higher profit margins, enabling innovation that can raise productivity even further.
But the restructuring or exit of inefficient firms is more than just a source of growth for China. It is arguably also the country’s surest source of growth. China can also become more productive by continuing to adopt frontier technologies from advanced economies, but rival powers have imposed lasting technology blockades that stifle this approach. The United States, for instance, continues to restrict countries like Japan and the Netherlands from exporting computer chips made using advanced US technology. Restrictions on US investment in Chinese or Chinese-owned enterprises working on sensitive technologies—such as quantum information systems and artificial intelligence—have similarly stiffened over the years.
While these restrictions have impeded frontier technology transfers to China, they did spur domestic innovation in China. One may therefore think that quality innovation can make up for the productivity gains that local governments have been incentivized to forgo under the cadre evaluation system. Much as developing a five-nanometer process for the mass production of cutting-edge AI accelerators is no small feat, it does not necessarily extend to mean consistent innovation across a wide range of industries. Compared to the restructuring or exit of inefficient firms, innovation is a less certain source of productivity-led growth. Outcomes in research and development are inherently uncertain, while pruning industries with unnecessary overgrowth is almost sure to leave space for truly productive firms to grow. Moreover, even in emerging economies like China, new ideas are becoming harder to come by, as much of the foundational knowledge in technical fields has already been discovered. While some may point to the sharp rise in the number of active patents in China over the last few years as evidence of productivity improvements, the extent to which that truly reflects quality innovation and genuine technological progress remains unclear. The challenges China faces in both frontier technology imports and domestic innovation highlight the greater certainty with which the restructuring or exit of inefficient firms would lead to economic growth.
This efficiency-oriented approach to economic growth becomes even more crucial when one considers the abatement of China’s earliest tailwinds to growth. China’s decelerating growth since the 2010s stems in part from diminishing returns to its investment in physical capital, which naturally set in as an economy grows. In other words, additional machines and infrastructure have yielded smaller increases in real GDP over time. Another structural factor behind China’s economic slowdown is its aging population. The country’s demographic boom, which was a key driver of economic growth, is long over. For at least a decade, China’s cohort fertility rates have remained well under the replacement rate of 2.1 births per woman. Reforms to the one-child policy in 2015 and 2021 have also been largely unsuccessful in reversing the fertility decline. Experts predict that subsequent shrinkages in China’s working-age population will lower its projected per-capita GDP growth over the next decade by a tenth. As China exhausts these early growth drivers, capitalizing on approaches that can guarantee increases in productivity becomes paramount, especially since per-capita incomes in China are merely two-fifths of the G7 average. And that is most certainly achieved through the restructuring or closure of inefficient firms.
Once a dynamo for China’s economic growth, the cadre evaluation system has become a denier of not just any source of growth, but the country’s most guaranteed source of growth. Keeping inefficient firms afloat to maintain employment at the expense of productivity-led growth may be a sensible trade-off in many other economies, which have already pruned a greater number of inefficient industries. But this is not the case in China. Whether noticing this consequence would ultimately lead to effective revisions of the cadre evaluation system is unclear. What is clear, however, is the need for China to first notice the gold mine of growth from which it is about to walk away.