China Can Maintain Its Economic Growth

By+JOHN+ROSS

EARLIER this year sections of the Western media tried to spin a story that the world economy was experiencing “severe slowdown in China” and “strong recovery in the U.S.” In other words， Chinas economy was allegedly in trouble and the U.S. was doing well.

Now that the factual data is in for the first half of the year it shows the opposite was true. Chinas economic growth was 7.5 percent to the second quarter of 2014； that of the U.S. was 2.4 percent. Chinas economy thus grew more than three times as fast as the U.S.s.

Still more significantly for the U.S.， its own statistical agencies and the IMF have officially revised their projections for long-term U.S. growth. Both now estimate it at only two percent. The Economist， somewhat cruelly， carried a cartoon of the U.S. as a tortoise on its front cover， stating bluntly that U.S. “l(fā)ong-term growth has slowed.”

My calculations for the U.S. economy are marginally more optimistic. Over the last 20 years U.S. average annual growth was 2.4 percent， and there is no short-term reason why it should slow. But this is a detail. Either estimate means the U.S. will remain on a path of two to three percent annual growth.

What are the comparative prospects for Chinas economy – not over the next few months， but over the longer term， say to 2020？ To answer this requires going beyond immediate news events and short-term fluctuations to the fundamental factors determining Chinas economic development.

It should be clarified from the start that Chinas policy aim over the medium/long-term is not to maximize GDP growth. This is explicit， indeed it has become commonplace in China recently to say that what matters is not the quantity of growth but its quality.

But this is a stereotype， empty phrase， of the type Chinas President Xi Jinping stressed must be avoided， un- less the criteria for “quality” and how it is to be measured is specified. The only correct measure can be the overall well-being and national security of China – summarized in its goal of “comprehensive national renewal.”

This correctly contextualizes economic growth. Economic growth is not an end in itself， but an indispensable means to achieving the desired ends. International comparisons show that more than 80 percent of consumption growth and over 70 percent of life expectancy （the latter reflecting factors such as health care and environmental quality） is determined by economic growth.

For those at the bottom of the income ladder， economic growth is particularly crucial. The Oxford Poverty and Human Development Initiative recently studied the correlation in all countries between GDP per person and the international Multidimensional Poverty Index （MPI）， which considers 10 indicators including nutrition， child mortality， and years of schooling. An extraordinarily close correlation was found – as The Economist noted：“Economic growth may thus not only be the best way to overcome extreme poverty， but also to reduce terrible non-economic social ailments as well.”endprint

As high living standards， which require high consumption， good environment， quality health care and poverty elimination， would certainly be at the top of the list if China is to maintain rapid overall progress， sustained high economic growth is indispensable. Fortunately， examination of economic fundamentals shows that， provided no major policy mistakes are made， China will continue to outperform all other major economies for a prolonged period.

Examining Chinas economic foundations， any economys growth is necessarily determined by two simple ratios. The first is what percentage of the economy is invested. Modern economic research shows that 57 percent of growth in an advanced economy is due to capital investment， 32 percent to increases in labor， and only 11 percent due to productivity increases（technically known as Total Factor Productivity – TFP）.

Developing economies， such as China， at present have the advantage of being able to apply technologies from more advanced economies without having to pay the research costs of developing them – a benefit known as“catch up.” In Asian developing economies， for example， 22 percent of growth is due to productivity increases compared to only 11 percent in developed economies， as the chart shows.

But the advantage of being able to borrow technology without paying development costs disappears as an economy becomes more advanced. Therefore， the role played by productivity growth falls as an economy moves to higher income levels， while the role played by capital investment increases， as the chart shows. The percentage of growth accounted for by productivity increases declines from 19-22 percent in developing economies to 11 percent in advanced ones.

By 2020 China will be on the verge of becoming a “high income” economy， according to World Bank criteria. As China is no more exempt from the rules of economic growth than any other country， its growth strategy must therefore assume that as it becomes more developed its growth will become more and more dependent on capital investment and less on productivity increases.

To meet this challenge Chinas advantage is that its investment level， 47 percent of GDP， is the highest of any major economy – providing a solid basis for long-term growth. Maintaining such a high level of investment is the first essential for Chinas rapid growth， while reduction in investment would be negative for growth.endprint

The second key ratio determining economic growth is “how much bang you get for a buck” from investment. Technically this is known as ICOR （incremental capital output ratio） – the percentage of GDP that has to be invested to generate one percent GDP growth.

So far Chinas situation in this respect is also satisfactory. Taking the average for the latest three years for which there are data， to avoid distortions by short-term fluctuations， China invested 5.1 percent of GDP for each one percent economic growth， whereas the U.S. had to invest 7.9 percent. Chinas investment was therefore about 50 percent more efficient than that of the U.S. But Chinas investment efficiency has fallen – the gap used to be bigger.

A key reason is the slowdown in Chinas industrial growth. Productivity increases in services are much slower in all countries than in industry. But in the last three years Chinas industrial growth has significantly decelerated to around nine percent a year， as shown in the chart.

It is too early in Chinas development to shift from a manufacturing to a service based economy. To take a comparison， South Korea is still an economy dominated by manufacturing but Chinas per capita GDP is only one quarter to one third of South Koreas， depending on the measure used. A premature shift from industry to services would therefore lead to a significant decline in Chinas economic efficiency.

So far the problem is not serious – nine percent industrial growth is sufficient to achieve Chinas 7.5 percent GDP growth target. But any further industrial deceleration would be damaging as services are no substitute for manufacturing industry in productivity growth.

Maintaining the competitiveness of Chinas industry will therefore be the key to maintaining its overall economic efficiency and growth in the coming years.endprint