What’s Happened to China’s Economy?

Last January, China’s government forecast that the country’s economy – which, at the time, was experiencing a strong rebound after the initial pandemic slowdown – would grow by 5.5% in 2022. But by the second quarter, unfortunately, the rapid spread of the Omicron variant of COVID-19 had forced the government to implement emergency containment measures in its most economically dynamic cities, including Beijing, Guangzhou, Shanghai, and Shenzhen.

The two-month Shanghai lockdown, in particular, dealt a devastating blow to growth, as the entire Yangtze River Delta was effectively sealed off from the global economy. It also shook business and investor confidence. Even if they still have faith in the Chinese economy’s long-run prospects, too many entrepreneurs and investors – both foreign and Chinese – have become more cautious than ever in doing businesses there, at least in the short run. The effects of this shift will be certain to persist, even after economic activities – which have not recovered more than three months after the lockdown was lifted – return to their previous level.

It looks like what happened to the economy since March was avoidable. The fact is, despite being pursued only to a limited extent, local-level policy innovation helped Shanghai to minimize the pandemic’s economic impact in the two years preceding the March 2022 lockdown. Given this, it is reasonable to consider the role that such innovation could play in mitigating damage to the business and investment environment caused by pandemic-containment measures.

Local-level innovation is not incompatible with the implementation of the national COVID-19 policy framework; on the contrary, failure to tailor policies to local conditions can weaken their impact. Yet so far, most local governments have not adopted innovative approaches to implementing pandemic-related policies, and in many cases they have implemented such policies much more aggressively than required. That is because local officials fear the consequences of failure, which could include losing their jobs.

There is of course good reason for holding government officials accountable for their decisions, and China has long had mechanisms in place for doing so. But the focus of accountability in China has recently shifted to the side of punishing wrongdoing without incentivizing officials to do the right thing. And such a shift has obviously been strengthened with the expansion of local governments’ mandate to include critical imperatives like managing financial risk and reducing pollution. When it comes to COVID-19, this has helped to ensure that responses everywhere meet a high standard.

But a lack of willingness by local governments to innovate policies carries severe economic costs. Highlighting them may well be the most consequential effect of recent lockdowns in China.

Since April, after recognizing the huge economic cost imposed by its pandemic-control policy, the central government has introduced a series of policies aimed at easing the financial constraints on micro, small, and medium-size enterprises that have been hurt by COVID-19-containment measures, and it has worked to restore supply in specific sectors, including automobiles, electronics, and transportation. But local governments are still enforcing strict mobility-control policies, which of course hamper cross-border economic activities – crucial to economy-wide recovery – despite having been repeatedly instructed by the central government not to do so. Officials would rather sacrifice short-run economic performance than risk their positions.

This represents a notable shift from the past. Since Deng Xiaoping launched his “reform and opening-up” agenda in 1978, China has usually managed to strike a dynamic balance between local-government accountability and local policy innovation, thereby maximizing the benefits and minimizing the costs of both. Local governments have long served as a major source of policy innovation in China. While the central government drew up the main policy roadmap, local governments were encouraged and inspired to pursue policy innovation, experimentation, and adaptation.

Because local governments were empowered to adapt policies and programs to their context, policy shocks became less likely. This counteracted the shortcomings of China’s formal institutions and allayed private-sector concerns about protection of property rights, access to markets, and infrastructure, thereby helping to spur dynamism at all levels of the economy. Local-level policy innovation thus played an integral role in driving China’s “economic miracle.”

In recent years, however, such local innovation has become increasingly rare. This is partly because local officials fear the political consequences, and the central government’s strengthened anti-corruption drive has exacerbated their anxiety. But the changed behavior of local governments may also reflect changes to their core incentives, caused by China’s apparent efforts to move away from the decentralized system of the past.

This change will have far-reaching implications for the economic development of China. Unless China commits to pursuing comprehensive structural reforms and building a more complete market system, a move away from the regionally decentralized system of the past will expose the flaws in its economic system. Those flaws – which local-government competition under a regionally decentralized system at least partly mitigated – will become obstacles to economic dynamism and sustained growth.