What happened to China’s growth?

In January, the Chinese government predicted that the country’s economy – which at the time was experiencing a strong rebound after the pandemic slowed – would grow by 5.5% in 2022. But by the second quarter, the spread of the Omicron variant it had forced the government to implement emergency lockdown measures in its economically most dynamic cities, including Beijing, Guangzhou, Shanghai and Shenzhen.

The two-month lockdown in Shanghai, in particular, dealt a devastating blow to growth., as the entire Yangtze River Delta has been cut off from the global economy. It has also shaken businesses and undermined investor confidence. Many entrepreneurs and investors – both foreign and Chinese – have become more cautious than ever in doing business, at least in the short term. The effects of this change will persist, even after economic activities – which have not recovered more than three months after the lockdown is lifted – return to their previous level.

It seems that what has happened to the economy since March is avoidable. The fact is that, despite being implemented only to a limited extent, local policy innovation helped Shanghai minimize the economic impact of the pandemic in the two years leading up to the March 2022 lockdown. Consider the role that such innovation could play a role in mitigating the damage to business and the investment environment caused by the lockdown measures linked to the pandemic.

Innovation at the local level is not incompatible with the implementation of the national policy framework against Covid; on the contrary, failure to adapt policies to local conditions can weaken their impact. However, to date, most local governments have not adopted innovative strategies to implement pandemic-related policies and, in many cases, have implemented those policies much more aggressively than necessary. This is because local authorities fear bankruptcy, which could include job loss.

There are good reasons to hold government authorities accountable for their decisions, and China has long had mechanisms to do so. But the focus of accountability in China has recently shifted to punishing wrongdoing rather than encouraging people to do the right thing. And that change was obviously reinforced by expanding the mandate of local governments to include critical imperatives like financial risk management and pollution reduction. When it comes to Covid, this has helped ensure that responses everywhere are similar.

However, the unwillingness on the part of local governments to innovate entails heavy economic costs.

Since April, after acknowledging the huge economic cost imposed by its pandemic control policy, the central government has introduced a series of policies aimed at easing financial constraints on the micro, small and medium-sized enterprises that have been affected by the containment of Covid, and this has served to restore supply in specific sectors, including the automotive, electronics and transport sectors. But local governments are still implementing strict mobility control policies, impacting cross-border economic activities – crucial for the recovery – despite repeated instructions from the central government not to. Authorities prefer to sacrifice short-term economic results rather than jeopardize their jobs.

This represents a notable change from the past. Since Deng Xiaoping launched its “reform and opening” program in 1978, China has generally managed to strike a dynamic balance between local government accountability and local political innovation, thereby maximizing benefits and minimizing costs of both. Local governments have long been an important source of innovation in China. While the central government charted the main political roadmap, local governments were always encouraged and motivated to initiate innovation.

As local governments have been allowed to tailor policies and programs to their context, political shocks have become less likely. This compensated for the shortcomings of China’s formal institutions and dispelled private sector concerns about the protection of property rights, market access and infrastructure, thus helping to foster dynamism at all levels of the economy. Political innovation at the local level has therefore played a key role in China’s “economic miracle”.

In recent years, this local innovation has become less frequent. This is partly due to the fact that local authorities fear political fallout and tougher anti-corruption measures from the central government. But the different behavior of local authorities could also reflect changes in their incentives, caused by China’s apparent efforts to move away from the past decentralized system.

This change will have far-reaching implications for China’s economic development. Unless China undertakes to implement comprehensive structural reforms and build a more comprehensive market system, a move away from the regionally decentralized system of the past will expose the flaws of its economic system. These errors, mitigated at least in part by competition from local governments in a regional decentralized system, will become obstacles to economic dynamism and sustained growth.