Jun 1, 2015 KEYU JIN

One of the most baffling features of China’s economic rise is that even with double-digit GDP growth, employment grew by a measly 1.8% annually, on average. Households, it seems, have largely missed out on the benefits of rapid development.

BEIJING – Chinese Prime Minister Li Keqiang recently cited job creation as vital to his country’s “ultimate goal of stability in growth.” His observation could not be more accurate. In fact, one of the most baffling features of China’s economic rise is that, even amid double-digit GDP growth, employment grew at a measly 1.8% average annual rate from 1978 to 2004. Households, it seems, have largely missed out on the benefits of economic development in China.

The superficial explanation of the discrepancy between GDP growth and job gains attributes the gap to the restructuring of inefficient state-owned enterprises (SOEs), which caused public-sector employment to plummet, from 112.6 million to 67 million, from 1995 to 2004. But there is a more fundamental cause: China’s bias toward industrialization. China’s government has long viewed industrialization as the key to modernization. During Chairman Mao’s Great Leap Forward, scrap metals were melted to meet wildly optimistic steel-production targets and thus to propel rapid industrial development. Today, the government promotes industrial and infrastructure projects that, by encouraging investment and generating tax revenues, enable the economy to meet ambitious – though no longer harebrained – growth targets.

The problem is that the manufacturing sector does little to create jobs, largely because relatively high productivity growth in the sector – averaging more than 10% annually over the last two decades – constrains demand for more workers. By contrast, China’s services sector has registered only about 5% annual productivity growth, and thus is a much more effective engine of job creation.

In fact, services are responsible for the lion’s share of employment in most advanced economies. But, whereas 80% of the American labor force was employed in service industries in 2012, only 36% of China’s workers worked in the sector. To bolster employment in services, China’s government must loosen its regulatory grip, ease barriers to entry in branches like telecommunications, and encourage labor mobility.

China’s focus on industrial production is problematic in another respect: it is extremely capital-intensive, owing largely to the distortions wrought by government policies. Beyond keeping interest rates below market levels, the government offered the automobile, machinery, and steel industries, among others, preferential access to cheap credit, favorable tax treatment, and public investment support. Such policies spurred firms to adopt capital-intensive technologies, obscuring labor’s natural comparative advantages.

At the same time, the government’s interventions have limited the growth of private-sector firms by impeding their access to finance. Though SOEs employ only 13% of the total workforce, and contribute about 30% of GDP, they absorb half of all investment. Together, banks and the government provide about 35% of investment in SOEs, but only 10% of investment in private companies.

But private firms are significantly more labor-intensive than SOEs – which use almost four times as much capital – and thus have been responsible for most of China’s job creation in recent decades. With average employment growth of 10.4% per year, the formal private sector partly compensated for the SOE layoffs from 1995 to 2004. The informal sector grew even faster, at an annual rate of 24%, albeit from a low base.

Given the obvious benefits of a flourishing and rapidly expanding private sector, China’s government should take steps to ensure that such firms – especially the small and medium-size enterprises that so often are crowded out of credit markets – can access the capital they need to expand. This would inevitably lead to a surge in job creation.

The uncomfortable truth is that Chinese households have benefited far too little from the country’s economic-growth miracle. Indeed, households’ share of national income has declined considerably in the last decade, in sharp contrast to the advanced economies, where households’ share is consistently high.

By allowing the private sector to flourish, and encouraging the shift toward a services-oriented economy, China’s government could bolster employment growth and, in turn, domestic consumption. As Li seems to recognize, structural rebalancing is needed not only to improve Chinese citizens’ wellbeing, but also to bolster economic and social stability at a time of profound global uncertainty.