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Business News/ Opinion / Zhang Jun | China’s untapped growth potential
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Zhang Jun | China’s untapped growth potential

Considering that China's per capita income amounts to only about 10-20% of that of the US, its growth potential, going by the convergence hypothesis, is far from tapped

Illustration: Jayachandran/MintPremium
Illustration: Jayachandran/Mint

China’s economic slowdown from a nearly 10% annual output gain in 2007 to below 8% today has fuelled speculation about the economy’s growth potential. While it is impossible to predict China’s growth trajectory, understanding the economy’s underlying trends is the best way to derive a meaningful estimate.

Whereas short-term demand largely dictates an economy’s real growth rate, its potential growth rate is determined on the supply side. Some economists cite indicators like investment ratios, industrial value-added, and employment to compare China to Japan in the early 1970’s. After more than two decades of rapid growth, Japan’s economy slackened in 1971, leading to four decades of annual growth rates averaging less than 4%.

This correlation is reinforced by the convergence hypothesis—the benchmark theory for estimating an economy’s potential growth rate—which states that a rapidly growing developing economy’s real growth rate will slow when it reaches a certain share of the per capita capital stock and income of an advanced economy. Economists Barry Eichengreen, Donghyun Park and Kwanho Shin say that share is about 60% of US per capita income (at 2005 international prices).

At first glance, the experiences of Asia’s most advanced economies—Japan and Asian Tigers Hong Kong, Singapore, South Korea and Taiwan—seem to be consistent with this theory. In 1971-73, Japan’s per capita GDP fell to roughly 65% of that of the US in purchasing-power-parity terms, while the Asian Tigers experienced downturns when they reached roughly the same income level relative to Japan.

But Eichengreen, Park, and Shin also found that once this income level is reached, growth rates tend to fall by no more than 2 percentage points. This means GDP growth should have slowed gradually in Japan after 1971, instead of by more than 50%. Likewise, given the remaining income gap with the US, the Asian Tigers should have grown faster than they have in the last two decades. But they each suffered a substantial slowdown.

These inconsistencies can be explained by external shocks. During Japan’s economic boom, its total factor productivity (TFP, or the efficiency with which inputs are used) contributed about 40% to GDP growth. When growth plummeted, TFP fell even faster—a change linked to the 1971 yen appreciation and 1973 oil crisis.

A sudden exchange rate shock and sharp increase in oil prices impede firms’ ability to adjust their technology and production methods to meet new cost conditions, undermining TFP growth. Such a cost shock has a more prolonged effect than a negative demand shock. Without negative external shocks, exorbitant TFP growth would have declined gradually, as returns from institutional adjustment, resource reallocation and technological catch-up diminished, in accordance with the convergence hypothesis.

External shocks also explain China’s GDP slowdown since 2007. The renminbi’s appreciation against the dollar is the cost shock’s main driver, but the demand shock after the 2008 global financial crisis worsened the situation. TFP has likely declined substantially as China’s economy has slowed in response to these shocks.

Unlike Keynesians who focus on demand shocks, followers of Austrian economist Joseph Schumpeter see cost shocks as important catalysts for structural reform and industrial upgrading, both of which are needed to avoid falling into a low-growth rut in the long term. In the short term, a cost shock devastates some economic activities, forcing firms either to shut down or move to another business. What Schumpeter called “creative destruction" can aid the emergence of new, more efficient firms.

The problem is that many country-specific factors, such as political concerns and vested interests, can impede this process. In this sense, China’s government is facing an important test. If it fails to take advantage of the opportunity provided by the cost shock and economic slowdown to roll out structural reforms, China’s potential growth rate, as dictated by TFP, will never rebound fully.

Because improving productivity is the best way to counter cost shocks, the new round of structural reform should be aimed at creating conditions for economic transformation by establishing a level playing field guided by market rules, reducing government intervention and stopping protecting inefficient businesses.

Indeed, considering that China’s per capita income amounts to only about 10-20% of that of the US, with massive regional differentials within China, its growth potential, going by the convergence hypothesis, is far from tapped. But the degree to which it can fulfil it will depend largely on its TFP prospects.

In 2007, economists Dwight Perkins and Thomas Rawski estimated that, in order for China’s economy to maintain a 9% growth rate and a 25-35% investment ratio until 2025, it would need an annual TFP growth rate of 4.3-4.8%. Given that China’s TFP growth has averaged 4% for over 30 years and is likely to slow in the coming decade, this scenario is improbable.

Maintaining 6% annual GDP growth with the same investment ratio would require annual TFP growth of only 2.2-2.7%. With China’s productivity still well below that of developed countries, and allocational efficiency likely to improve in the next 10 years as labour and capital are redistributed, 3% TFP growth is feasible. Aided by structural reform, China’s economy could expand even faster, achieving 7-8% annual growth over the next decade. Either way, convergence will remain swift.

©2013/PROJECT SYNDICATE

Zhang Jun is professor of economics and director of the China Center for Economic Studies at Fudan University, Shanghai.

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Published: 15 Nov 2013, 03:34 PM IST
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