Extending the horizon—China’s medium and long term economic outlook

For a while, after the global crisis broke out, we were all preoccupied with short term prospects and developments. More recently, it has become clear that China’s economy is actually growing quite well, helped initially by a massive policy stimulus but with growth having become more broad based recently. At the same time, the global outlook is more subdued now than before the crisis. In all, this is a good time to extend the perspective and revisit medium and longer term economic prospects.

I recently wrote a working paper that discusses a medium term scenario building exercise. The objective was to get a sense of how the pace and composition of growth may develop, both from the production (supply) side and the expenditure (demand) side; whether the outlook has changed because of recent events and what the key implications of the outlook are; and how China’s living standards and the size of the economy may compare internationally in 2020.

I would of course prefer it if everybody diligently read the whole paper (526kb pdf). But, if you have better things to do in the summer during the World Cup Football, here are the key take aways.

China’s trend growth is on course to gradually decline in the medium term, but to a still respectable pace. The paper uses a pretty standard growth accounting framework, where potential GDP (trend growth) is determined by labor, capital, and technological progress (“total factor productivity”, or TFP). In the coming decade, the contribution from labor is likely to come down in line with lower and eventually negative expansion of the working population because of demographic developments. I also argue that TFP growth will come down a bit, largely because the room for productivity growth in manufacturing production eases along with the expected export deceleration. And, with some rebalancing expected, capital accumulation should also start to slow.

The deceleration of trend growth has implications for policymaking. Trend growth remains respectable. At 6.7 % in 2020 it still compares favorably internationally. However, in the coming years, when growth targets are being set, this slowdown in potential growth needs to be acknowledged. After several years of double digit growth before the crisis, this may require an adjustment of expectations among some policymakers and the public as to how rapidly China can grow without running into macroeconomic tension. Also, the expected deceleration places a premium on policies that can increase sustained productivity growth, for instance via more reallocation of labor into high productivity activities, more rapid buildup of human capital, and more innovation.

Taking an expenditure perspective, with some—but no drastic—further rebalancing expected, the share of consumption in GDP is likely to rise somewhat through 2015. China’s government is aiming at rebalancing the pattern of growth, reducing the reliance on investment and industry, increasing the reliance on consumption and services. In my view, some good first steps have been made. However, compared to the strong momentum of the traditional pattern of growth, the measures implemented so far have been modest and, based on them, we can only expect modest rebalancing of the pattern of growth. Thus, in this scenario, the ratios of investment and saving in GDP edge down gradually.

Exports may be outpaced by the domestic economy. With economic growth in China likely to continue to be robust, import volume growth remains solid. Meanwhile, given the outlook for the world economy, unlike in 2000-07, exports may not outgrow domestic activity in 2010-2015, despite good competitiveness and further market gains. Thus, with export price increases assumed to lag domestic inflation, the export to GDP ratio will probably diminish (see Figure 1). This would represent an important gradual shift in the nature of China’s economy. Also, after modestly positive contribution of net trade to growth this year and next, this scenario sees this contribution at broadly zero in 2012-2015.

The external surplus would continue to rise in US dollar terms, not as a share of GDP. This scenario uses fairly benign medium term projections for raw material prices from the World Bank. On this basis, the trade surplus would edge up in US dollar terms but gradually decline as a share of GDP, from 5.1 percent in 2009 to 2.7 percent in 2015 (Figure 2). The current account surplus would rise substantially in US dollar terms and hold up, as a share of GDP, because of rising income on growing foreign assets (Figure 3).

The paper also explores various ways to compare China’s living standards and the size of the economy with that of other countries in the future. In 2020 China’s GDP per capita would be broadly comparable to the current level in Latin America, Turkey and Malaysia. Adjusted for purchasing power, in 2020 China’s GDP per capita would be one-fourth of the US level and China’s total economy larger than that of the US.

The pace of catch up in current prices and market exchange rates will depend on the extent of real exchange rate (RER) appreciation. Past experience internationally suggests that, with a large portion of labor employed in agriculture, RER appreciation may be modest in the coming decade. This may be surprising, given the intensified discussions on a possible exhaustion of surplus labor in China. However, compared to historical patterns in other countries, China is not yet at the stage where the exhaustion of surplus labor leads to a structural tightening of the LM and RER appreciation. In principle it is possible that things are different in China, maybe because demographic changes associated with ageing will affect the country at a relatively early stage of development. The demographic changes are actually rather gradual and would not have a dominating influence in the coming years. Indeed, there are still so many people employed in low value added activities in China, both in cities and in rural areas, that it seems much too early to me to foresee an exhaustion of surplus labor any time soon. Nevertheless, reflecting the uncertainty, the paper presents 2 RER appreciation scenarios, suggesting China may become the largest economy on this metric sometime between 2020 and 2030.