How Long Can the Chinese Economy Continue to Grow?

From: English Edition of Qiushi Journal Updated: 2013-11-07 15:26
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Since the year 2010, there has been a marked rise in global interest over where China’s economy will go in the future. Why is the Western world so interested in the future of the Chinese economy all of a sudden? Put simply, this is mainly because China’s economy is now a great deal bigger and more important than it was in the past. As a result, people are not only unable to ignore China’s economy, but must also predict how the global economic landscape will be influenced by it in the foreseeable future.

Recently, many investment banks in Wall Street have been pessimistic about the prospects of China’s future economic growth. But if we think carefully about the reasons behind this pessimism, we will discover that Wall Street hedge funds have likely realized that there is money to be made by hailing the decline of the Chinese economy at present.

Unsurprisingly, a number of renowned economists have been among those hailing the decline of China’s economy. These economists believe that China’s economy will run into major problems within a few years and possibly even stagnate. Optimistic projections, on the other hand, have not nearly been as well received. This is quite perplexing.

Admittedly, there is a degree of difficulty involved in ascertaining how long China’s economic growth will be able to continue. The only way of answering this question is to conduct serious research.

Why has China been able to achieve high growth?

The scale of China’s economy as measured according to current year prices has reached almost 50 trillion yuan, which means that it has now grown to almost half the size of the US economy if calculated in US dollars. Not only is China’s economy large, but it is also growing at an extremely fast rate. Measured in nominal prices, China’s economy has basically doubled in size every five years. Even when measured according to comparable prices, it has still managed to double in size every seven years. As a result of this rapid growth, China’s GDP surpassed that of the UK in 2005, that of Germany in 2007, and that of Japan in 2010, making China the second largest economy in the world. At the present rate of growth, it is highly likely that China’s GDP will catch up with or even surpass that of the US at some point around the year 2020, provided that a difference of 3.5 to 4 percentage points can be maintained in the growth rates of the two countries.

A technician fits out the interior of a Diamond-Series light plane in an avionics workshop of the Shandong Bin Ao Aircraft Industries Co., Ltd. According to figures published by the National Bureau of Statistics of China on July 15, 2013, the Chinese economy grew 7.6% year-on-year during the first half of 2013. / Photo by Xinhua reporter Guo Xulei

Upon restoring data on the early economic history of the West, the famous economic historian Angus Maddison, who passed away recently, discovered that per capita incomes in Western countries grew extremely slowly prior to the 18th century. Maddison’s data showed that it took as long as 1,400 years for per capita incomes to double. It was not until the arrival of the Industrial Revolution, which began in the UK, and the resulting technological leap forward that economic development really began to pick up pace in Western countries. At that time a number of countries were able to achieve a 2-3% growth in per capita income per year. After the Second World War, a group of economies displaying exceptionally fast rates of growth appeared. These economies tended to be concentrated in East Asia, and included Japan and the “Four Asian Tigers.” They managed to maintain annual growth rates of 7-8%, which allowed their per capita incomes to double every decade. Therefore, it can be said that high growth doesn’t actually go back that far, having only really been with us for half a century or so.

In an attempt to better understand high growth, economists came up with the simple but important concept of convergence hypothesis. The basic idea of convergence hypothesis is that poorer economies have the potential to grow at a faster rate than richer ones. Why is this possible? There are two reasons: the small denominator of poorer economies makes it easier for them to achieve a higher growth rate; and more importantly, underdeveloped economies are able to emulate the institutions, technologies, and modes of production of richer economics, which enables them to catch up with the latter more easily. In contrast, leading countries tend to grow slowly, as they lack a target to catch up with.

This hypothesis is extremely important. At the very least, it helps us to understand why more economies are able to catch up today, and why they have achieved such outstanding results in development. However, this hypothesis does not tell us the conditions that an economy must meet in order to converge. In other words, it fails to answer the fundamental question of what a country needs to do in order to catch up. In order to answer this question, we must turn to literature on the economics of development and growth, which has attempted to explain the theory behind why certain economies are successful.

Economists have found that in order to achieve economic growth, a country must accumulate capital rapidly; without capital accumulation, there will be no growth. William Arthur Lewis, the winner of the 1979 Nobel Prize in Economics, held that the core of economic development lies in accelerated capital accumulation. Specifically, a country needs to significantly increase the proportion of savings and investment in its national income instead of simply using national income for the purpose of consumption. Why has growth stagnated in European economies that are in the midst of sovereign debt crisis? One reason is that they lack the impetus for growth due to their high levels of income. But even so, we can see that the national savings rates of these countries are very low. All the money they earn each year is spent on social security and other purposes, and nothing is left over. They even borrow for the purpose of spending or to cover social welfare expenditure. Therefore, low savings rates have become a serious problem for these countries.

In the 1960s, the economies of Hong Kong, Taiwan, Singapore, and South Korea achieved rapid economic growth. A common feature of these economies is that each had a high rate of savings.

However, is fast capital accumulation alone enough to bring about economic growth? The answer is actually no; technological advancements are also required. In the absence of technological progress, the marginal rate of return on capital diminishes as investment increases, making growth unsustainable. In fact, for developing and relatively undeveloped countries, it is crucial to ensure that captial accumulation is accompanied by sufficient technological progress.

China has maintained a high rate of investment over the last 20 years—even though its savings rate has still been higher than its investment rate for most of these years—which has led to the rapid increase of capital in its economy. China’s stock of capital has grown by an average rate of about 12% per year over the last 20 years, and its capital-output ratio has increased rapidly since the 1990s. It was during this period that China’s GDP recorded its fastest ever growth.

What should be noted is that the fast accumulation of capital in China has been accompanied by technological progress, which presents a stark contrast to the situation that was seen in the former Soviet Union. Moreover, China has mainly relied on foreign trade to achieve its technological progress. In the last 20 years, China’s import and export trade has grown extremely rapidly. The expansion of trade was primarily achieved through the introduction of foreign direct investment (FDI), which has been a major source of China’s technological advancements. Absorbing and assimilating foreign technologies through trade and FDI, gradually converting foreign technologies into domestic ones, and then upgrading these technologies constitute the primary means by which China has achieved technological progress.

The simple method of growth accounting can tell us whether or not a country’s capital accumulation is being accompanied by technological progress. The principle of growth accounting is to ascertain whether the weighted sum of factor growths is larger than the growth rate of total output. The difference between the two is referred to as the growth rate of total factor productivity (TFP). A growth-accounting analysis of the economy of the former Soviet Union conducted by economists found that the country’s TFP was only sound before the year 1965. After 1965, its TFP went from good to bad, and the entire economy was never able to rebound before the Soviet Union eventually collapsed. Application of the same method to analyze the “Four Asian Tigers” reveals a positive TFP. This is the fundamental distinction between these economies. Despite the fact that both the Soviet Union and the “Four Asian Tigers” had high rates of capital accumulation, the mechanisms behind their growth were totally different. Most Eastern Asian economies have demonstrated good TFP growth rates.

Studies so far have found that China’s TFP growth rate has remained sound during its rapid capital accumulation, growing at about 3%-4% per year on average and contributing to around 35%-40% of the country’s GDP growth. This is a good rate even compared to those of other East Asian economies. Moreover, China’s high TFP growth rate also helps to explain why China’s economy has been able to grow so fast. This is not only because of China’s accelerated capital accumulation and its constantly increasing investment rate. More importantly, the country has enjoyed remarkable increases in investment efficiency and very clear-cut technological progress.

How long can China’s economy continue to grow?

There is a great deal of interest at present with regard to how long China can maintain its rapid economic growth. Frankly speaking, economists do not yet have an effective means of predicting economic growth in the future. Despite this, however, convergence hypothesis can still help us to ponder the answer to this question, although doing so requires that we first look at the gap between the Chinese and US economies. The reason for this is simple: the wider the gap, the more potential for catching up.

Goldman Sachs made a bold prediction in 2003: the Chinese economy is unlikely to catch up with the US economy until the year 2041. Now it seems that this prediction was too conservative. But in fairness, when this prediction was made in 2003, China’s per capita GDP had only just exceeded US$1,000. Moreover, the prediction was based on Goldman Sachs’ assumption that China’s economic growth rate would drop from 10% to 5% during the time it would take for its GDP per capita to increase from US$1,000 to US$5,000. Looking back now, we can see that this assumption seriously underestimated China’s potential for growth.

The IMF also published a prediction in early 2011 with regard to China’s economy overtaking the US economy. However, this prediction was based on purchasing power parity (PPP). Calculated using PPP exchange rates, China’s GDP was actually US$11.2 trillion in 2010, twice as large as the GDP calculated according to China’s official exchange rate. But the GDP of the US, on the other hand, was unchanged at US$15.2 trillion when calculated according to PPP. On that basis, the IMF predicted that within five years (by 2016), China’s GDP would reach US$19 trillion, while the GDP of the US would be US$18.8 trillion. In this way, the Chinese economy would catch up with the US economy within five years. In addition, calculations also showed that China’s economy would account for 18% of the global economy at that time. Following this logic, China’s economy will account for approximately 25% of the global economy by the year 2020, calculated according to PPP exchange rates. This reminds me of a figure that the famous economic historian Augus Maddison once reconstructed: in the year 1820, China’s economy accounted for 28.7% of the world economy. Now it is looking like China’s economy will return to this point by the year 2020, a full 200 years later.

Then, after becoming the world’s largest economy in 2020, how long will China be able to keep on growing?

It is widely acknowledged that even if China’s economy equals that of the US in size by 2020, its per capita income will still be low, accounting for merely a quarter of that of the US. That disparity equates to the difference in per capita GDP that is seen between Shanghai and the US today. Supposing that the Word Bank’s criterion for classifying economies remains unchanged, if China’s GDP per capita reaches US$15,000 by the year 2020, China will still be located somewhere between a middle-income country and a high-income country. Moreover, its level of income will still be lower than that of the “Four Asian Tigers.” According to convergence hypothesis, China will still have the potential for economic growth. The question is how long can such potential be sustained? Let us approach this issue with the assistance of some reference data. 

First, China’s potential for future investment. China’s stock of capital was around 93.3 trillion yuan, or US$13.8 trillion, at the end of 2010, roughly twice the size of the GDP. The stock of capital in the US, on the other hand, was US$44.7 trillion at the end of 2010, representing more than three times that of China. China’s stock of capital per capita is even lower. In 2010, China’s capital stock per capita was only US$10,000, less than 10% of that of the US and 20% of that of South Korea. Despite the tremendous achievements that China has made in infrastructure construction, it still falls far short of the US in this respect. China’s railway lines, for example, are expected to reach a total mileage of 120,000 kilometers by the year 2015. This is slightly more than half of that of the US, which totals 220,000 kilometers. Moreover, the existing 90,000 kilometers of railroads in China are mainly concentrated in the country’s eastern regions, while the mileage of railway lines in central and western regions will not reach 50,000 kilometers until the year 2015. Despite having accelerated the construction of expressways over the last 20 years, China’s expressway density is still lower than the average for OECD countries, reaching approximately 70% of that figure. The density of expressways in inland China is even lower. Let us look next at China’s urban rail transit. China has almost 100 cities with a population of over 5 million people, but 80% of them do not have a subway network. Moreover, 90% of China’s subway mileage is located in the country’s eastern areas. Therefore, in this sense, even after the year 2020, there will still be huge potential for investment, and the Chinese economy will still have significant room for improvement, which is very important. In fact, even after China as a whole has entered the middle and high income stage, there will still be enormous potential for “catching up” to play out between different regions of the country. This is because there are huge disparities in the per capita stock of capital between China’s eastern region and its central and western regions, and between its coastal and inland areas. According to data from 2009, for example, GDP and capital stock per capita in coastal areas almost doubled that of 20 inland provinces (municipalities). As a rough estimate, if per capita GDP were US$12,000 in coastal areas and US$6,000 in inland areas respectively, and supposing that inland areas had a 9% growth rate while coastal areas had only 5%, then it would take approximately 20 years for inland and coastal areas to converge.

China’s economic growth will slow down after 2020, but not by too much. I believe there is every chance that China will be able to maintain a 6%-7% growth rate on average for another ten years after 2020. This is not only because there is a precedent for this—Eastern Asian economies maintained rapid growth after their per capita incomes had reached medium and high levels—but more importantly because regional disparities within China provide much room for increases in investment and productivity.

Second, future changes in China’s employment structure. As is known to all, a common feature of all industrialized economies is that when the growth focus in the economy shifted from the traditional agricultural sector to modern industrial and service sectors, the labor force shifted with it from farming to manufacturing and services. This change in the employment structure is an important sign of a country’s economic development. China is no exception. In the last 30 years, the proportion of China’s workforce employed in manufacturing and services has risen significantly, while at the same time the agricultural labor force as a percentage of the total workforce has dropped by 30%, representing an annual average decrease of 1 percentage point. In addition, value added from agriculture is currently responsible for about 10% of China’s GDP, and will continue to drop gradually. Studies show that value added from agriculture as a percentage of China’s GDP will probably fall to 5%-7% by the year 2030, which is near the level of developed countries. This means that China’s future economic development will continue to bring about the decrease of the labor force employed in agriculture. Supposing that this labor force decreases by one percentage point every year, it will take at least another 20 years for the agricultural labor force to drop from the current 30% of the total workforce to below 10%, thereby coming close to the share of value added from agriculture in the GDP.

Third, future changes in the rate of China’s urbanization. There was a piece of news that captured a great deal of attention in 2011. According to figures released by the National Bureau of Statistics of China, the rate of urbanization in China exceeded 50%, meaning that China’s urban population had surpassed its rural population for the first time. It took 30 years for the rate of urbanization in China to go from 20% to 50%. This equates to an annual increase of one percentage point on average. A single percentage point of growth is the same as more than ten million people from rural areas becoming urban residents. If this trend of growth continues, it will take another 20 years starting from now for China’s urbanization rate to reach 70%, which is the average rate for high-income countries. Therefore, I believe that even if China becomes the world’s largest economy by the year 2020, it should have at least ten more years to complete the transformation and modernization of its economic and employment structures, during which time it will be able to sustain a rapid economic growth.

Does China have the capacity to continue its economic growth into the future?

The question that everyone is asking at present is whether or not China’s rapid growth will still be possible in the future, and whether or not China will have the capacity for continued growth. In particular, people are asking whether China will be able to unlock and maintain the robust domestic demand needed to underpin sustained economic growth, and whether or not it will come to the forefront of technology and succeed in upgrading its industrial structure. Our discussion of these questions can be divided into two parts. The first part concerns the trend of domestic demand, particularly consumer demand and changes in the savings rate. The second part relates to technological progress and the upgrading of the industrial structure in the future. Because both questions pertain to the “middle-income trap,” which is an issue of great concern at present, the discussion below will also help us to show why China is unlikely to fall into the “middle-income trap.”

First, demand as a condition for sustaining China’s rapid growth in the future. This needs to be discussed because the view that domestic demand is insufficient, and particularly the view that consumer demand is seriously insufficient, has become very popular at present. Based on the judgment that demand is insufficient in China, most people think that shrinking demand will prevent China from achieving sustained growth in the future, and that China’s growth is about to stop.

Frankly speaking, the decrease of consumption as a share of China’s GDP has always been a matter of doubt. This is because statistically speaking, the growth of household spending in China has not at all been slow. This growth is evidenced not only by the fact that China’s retail sales of consumer goods have grown at a nominal rate of over 17% annually in recent years, but also by the fact that household spending on housing, education, financial intermediary services, healthcare, and geriatric services have all witnessed rapid growth. Even after adjusting for inflation, these growth rates do not show a significant drop. A comparison of per capita consumption between China and other major Asian economies reveals that the growth rate of consumption per capita in China is significantly higher than the rates that were seen in Japan, Singapore, South Korea, and Chinese Hong Kong and Taiwan when those economies were experiencing high growth. Therefore, it is hard to understand why consumption as a share of China’s GDP has been on the decrease for the last 10 years.

What is certain, however, is that China’s total consumer spending as a share of its GDP remains low compared with developed countries. This is mainly because in its current stage of high growth and high accumulation, China needs to spend a larger portion of its GDP on investment and construction each year in order to increase its productivity and per capita stock of capital. Even if China’s rate of consumption has dropped, it has only dropped as a share of the GDP, and not in absolute terms. In this sense, there is no need to worry about China’s ability to tap its potential consumption demand in the future.

Even if China’s consumption as a share of the GDP has declined in the past, I am confident that it will increase on a constant basis in the future. First, as per capita income rises, the level of consumption in China will inevitably increase. Second, the process of urbanization will release potential for increases in housing expenditure. Third, the demand for equal access to education, healthcare, social security, and other public services will increase along with urbanization, which will provide a considerable boost to consumer spending on services. And fourth, as policies on low-income housing are gradually improved, consumer spending among a large number of low-income earners will increase.

The changes that are set to take place in the national savings rate also suggest that consumption will constantly increase in the future. Looking at the experiences of the “Four Asian Tigers” and Japan, we can see that each underwent a process in which savings rates first increased and then decreased. This process was largely due to demographic changes. The national savings rate increases when there is a demographic dividend, but drops when the demographic dividend diminishes. China’s sixth national census showed that the Chinese population is aging rapidly, as is the case in other Eastern Asian economies. The older a country’s population is, the lower its national savings rate will be. In fact, a UN prediction model tells us that savings among China’s major savers (people between the ages of 35 and 54) should peak at some point around the year 2010. This means that we can expect to see China’s national savings rate reach its peak almost any time now. After that, China’s household savings rate will begin to fall. In addition, the country’s public savings rate will also drop owing to increased government spending on pensions, healthcare, and other programs of social security, and government spending as a whole will grow proportionately. From this perspective, the current peak in China’s economic development and capital formation should last for another 15 to 20 years. This is a crucial period for the convergence of China’s economy with high-income, developed countries. The experiences of other countries tell us that after this peak, China’s economic growth rate is unlikely to be any higher than 5%, even though consumer demand will be playing a more important part in driving growth.

Second, China’s technological progress and the upgrading of its industrial structure in the future. Technological advances and the upgrading of the industrial structure are important indicators of economic development. Sustained economic growth and the increase of per capita incomes from US$5,000 to US$15,000, and even from US$20,000 to US$30,000, will depend on the constant upgrading of technologies and industries. Interestingly, the majority of people at present are pessimistic, doubting whether China will have the capacity to upgrade its technology and industrial structure in the future. These concerns derive from the dissatisfaction that these people have with regard to China’s current situation. They see that the country’s technological advances over the past 30 years have come primarily from the transfer of technology by means of foreign trade and foreign direct investment, while China’s capacity for independent R&D and innovation remains weak. Also, they are aware that even though China has become a major trading nation, the value-added rate of its exports remains low in overall terms. However, the problem is this: seeing the huge gap that exists between China and developed economies in terms of technological innovation and industrial structure, should we assume that China will be unable to maintain good momentum in its technological innovation and industrial upgrading in the future? This is not the way we should be thinking. The correct way of thinking is to see whether China has followed an essentially normal roadmap in its technological advancement and industrial upgrading, and whether China’s approach has conformed to general rules and practices. The normal way of thinking is to see that in most cases China will not be an exception to the rule. However, the tendency to always see ourselves as an exception has distorted our perspective, and this is something that we need to reflect on.

The experiences of other countries in economic development tell us that there is a very clear positive correlation between the upgrading of a country’s technology and industrial structure and the increase of its per capita income. Looking back over the last 30 years, we can see that significant changes have taken place to China’s industrial structure. Even in foreign trade, we have witnessed constant improvements in our export basket and in the sophistication of our exports. According to a study conducted by Harvard University economist Dani Rodrik, China’s export basket is almost as sophisticated as that of France. By measuring the sophistication of China’s export basket, Rodrik concluded that China’s per capita income should be three times higher than it is at present. Indeed, countries with a similar export basket to China’s have a significantly higher GDP per capita than China does.

The world of today is a flat one in which technological progress and trade are inseparable. The division of labor between developed countries and emerging market economies is now predominantly vertical, with countries no longer relying solely on closed-door R&D to promote technological progress. In this sense, China’s practice of importing technologies to develop the capacity to make localized technological innovations, a particularly important part of which has been importing and assimilating the technologies of transnationals via trade and investment, accords with international experiences and practices. Even in processing trade, which on the surface seems to be all about applying or assimilating the technologies of other countries, it has not been easy to do so well. A great deal of research has shown that a country must have a solid R&D foundation and a sound capacity for assimilation if it is to gain the kind of positive spillover effect from foreign technology that will drive the localization of technology. Having benefited from the rapid accumulation of well-educated human resources, China’s performance in this regard has clearly not been disappointing.   

In 2011, the World Trade Organization (WTO) released a study on changes in trade patterns that it conducted in collaboration with the Institute of Developing Economies of the Japan External Trade Organization (IDE-JETRO). By analyzing 2008 data from the Asian International Input-Output Table prepared by IDE-JETRO (this data covered Japan, Indonesia, South Korea, Chinese Taiwan, Thailand, Malaysia, the Philippines, Singapore, and China) the report estimated that the average domestic share of trade-weighted value added from exports in these 9 countries and regions was 72%. The report revealed that the domestic share of value added from the exports of China’s mainland was 63%, higher than that of Singapore and Chinese Taiwan, and close to that of South Korea and Thailand. This shows that China is not lagging behind the other major Asian economies in terms of the technical sophistication and value added of its exports. At the same time, this figure is also a reflection of China’s achievements in promoting technological advancement and structural enhancement in its manufacturing sector. The WTO-JETRO report also indicated that the US and Japan were very close to each other in terms of the domestic share of value added of their exports, with figures for both countries being around 85%. This indicates that China and other Eastern Asian economies still need to improve their capacity to advance technologies and upgrade industrial structures if they are to catch up with developed industrial economies. In particular, these economies need to raise the share of value added from capital-intensive and technologically sophisticated industries whilst constantly reducing the share of exports from the processing trade.

China’s nationwide campaign to develop science and technology and encourage independent innovations over the past 10 years will bring about significant enhancements in the country’s R&D capabilities, and will play a significant role in the upgrading of technology and the industrial structure in the next 20 years. The experiences of OECD countries tell us that raising R&D spending to 1% of GDP usually requires a considerable period of time; but once R&D spending as a share of GDP exceeds 1%, it will start to grow very rapidly. This is what economists refer to as the “take-off of science and technology.” China has now entered this take-off stage. China’s R&D spending as a share of GDP has reached 1.7%, and it will rise to 2% very quickly. At present, R&D spending in China is growing at a rate of about 6% per year, which is equivalent to that of South Korea and Singapore. This is one of the fastest growth rates in the world at present. According to the National Medium- and Long-Term Program for Science and Technology Development (2006-2020) promulgated by the State Council of China in 2006, R&D spending as a share of GDP is projected to reach 2.5% by the year 2020, while the percentage of imported technology will decrease from the current 50% of China’s total technology to 30%. The Program also projects that value added from China’s emerging strategic industries will rise from the current 3% of GDP to 15%. In recent years, China has made considerable progress in technology upgrading and independent innovation in the field of communications, and it will not be long before China’s independent R&D and innovation starts to produce the cutting edge technologies of the future.

Therefore, given China’s advantages in education, science and technology, and human capital, it can be said that as long as we continue to carry out a policy of open trade, participate actively in the vertical international division of labor, assimilate technologies transferred from other countries, and continue to increase spending on independent research and development, there is great hope that China will be able to move up the technology ladder quickly, upgrade its industrial structure on a constant basis, and establish itself on the cutting edge of technology.

(Originally appeared in Red Flag Manuscript, No.11, 2013)

Author: Professor and Director of the China Center for Economic Studies of Fudan University

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