2.4 Growth likely to slow with rebalancing and income convergence

In this section we discuss three arguments related to the sustainability of China's growth: whether investment- and export-led growth is sustainable; the parallels between China today and Japan in the 1980s; and whether China's growth is likely to slow as its per capita income converges with more developed economies. We conclude that China's growth rate is likely to slow as the economy rebalances and incomes converge, but that it is unlikely to fall sharply or undergo a protracted period of low growth and that it will remain high relative to advanced economies.

2.4.1  Investment and export growth to slow

There is considerable debate about the sustainability of China's investment-led growth.[23] Economic settings in China favour investment over consumption with the provision of cheap credit to corporates (encouraging investment), high returns to capital relative to labour (ie, high profitability vs. low wages) and under-developed financial markets which make it difficult for households to borrow for consumption. The relatively low exchange rate[24] also favours the export sector over domestic consumption by making exports cheaper in foreign currency terms and imports more expensive in domestic currency; in addition, the absence of a social safety net and low provision of state-funded health and education services encourage saving at the expense of consumption.[25] By liberalising financial markets and increasing the social safety net, authorities could encourage a shift from investment to consumption.[26]

Investment growth was in excess of 20% per annum in nominal terms in 2009 and 2010 and investment reached nearly 50% of GDP. Investment has generally fallen as a share of GDP in developed economies as a result of the GFC; for example, in 2009 the share in the US was 15% and in New Zealand 18%, a fall of five percentage points or more from a peak in the mid-2000s in each case.[27] Despite the scope for China to catch up with the developed world, its recent rate of investment growth cannot be sustained indefinitely. China is already an outlier in terms of the share of GDP accounted for by investment, as noted in section 2.1 of the accompanying paper (Bowman and Conway, 2013, p.6-7). Investment has peaked as a share of GDP at a lower level of GDP per capita in other developing Asian economies, suggesting that investment growth is due to peak in China, reducing the main driver of overall economic growth.

Furthermore, the high rate of investment growth, which has exceeded GDP growth for some time, implies a rising capital-output ratio, ie, increasing amounts of capital are being utilised to generate each additional unit of output, suggesting that investment is becoming less productive and that returns to capital are falling. However, total factor productivity growth has been high,[28] indicating that China still has a long way to go before reaching low (or negative) returns from investment. Nevertheless, the rapid growth in investment in recent years points to the possibility of some over-investment.[29] State-directed investment decisions and the composition of investment being heavily weighted towards infrastructure (which may not produce an immediate or monetary return) support concerns about the efficiency of investment.

Another way of approaching this issue is to examine China's incremental capital-output ratio (ICOR), the ratio of investment's share of GDP to GDP growth. A higher ICOR indicates less efficient investment as more investment is required to produce each additional unit of output. China's ICOR averaged around 4 for the decade from 2000-2009, but increased above 5 in the final year as investment's share of GDP increased and growth slowed, pointing to lower capital productivity.[30] IMF forecasts implicitly have the ICOR around 5.5 for the next five years with the investment-share of GDP high relative to real GDP growth. The credit implications of this were discussed in section 2.2 above; here we are concerned with whether the rate of investment growth - and so economic growth, given investment's large share of activity - can be sustained.

Guo and N'Diaye (2009) examine the sustainability of China's export growth and conclude that to maintain the recent rate of export growth would require large gains in global market share in some key industries. From a modelling exercise they conclude that China is unlikely to be able to achieve the required competitiveness through productivity growth, lower profits or subsidies. They examine other strategies which might be followed, eg, moving up the value chain, changing the composition of exports and diversifying the export base and increasing the value-added of exports, but conclude from other emerging Asian economies' experience that there are limits to the growth in market share that a country can achieve. They consider that a rebalancing of the economy towards higher private consumption growth would provide a partial offset to lower export growth.

Their conclusion is reflected in the Twelfth Five Year Plan which envisages a transition from exports and investment to consumption as the main driver of growth and, partly as a result, from manufacturing to services. According to the plan, growth will decline to 7% per annum in the 2011-2015 period. This figure acknowledges that growth will slow as the economy rebalances and so is lowering expectations from the rapid rates of growth achieved in the past three decades. Growth far exceeded its target of 7.5% per annum in the previous five year period, averaging around 10% per annum.

We consider that investment growth in China is likely to fall from its recent rate as the stimulus from the response to the GFC fades, but it is likely to remain relatively high because per capita incomes are still low (indicating that there is room for them to catch up) and per capita capital stock is low compared with developed economies. A high investment-to-GDP ratio on its own will not constrain growth as long as the capital-output ratio is still low and the investment is generating positive returns. However, a decline from the recent high rates of investment growth is expected.[31]

2.4.2  Parallels with Japan in the 1980s are weak

Figure 4 – Investment as a share of GDP

Source: IMF (2013)

Some commentators have claimed that there are parallels between China's recent growth and Japan's performance in the 1980s, which suggests a sharp slowing in growth for China.[32] They argue that, at nearly 50% of GDP, China's investment-share is much higher than Japan's was in 1980 (Figure 4) and that this indicates a heightened risk of slowing growth. Japan's growth in the 1980s was dominated by investment, supported by a high saving rate, and by exports, resulting in a large current account surplus. Japan's expansion was fostered by an undervalued exchange rate (until the Plaza Accord in 1985) and rapid credit growth which led to asset price bubbles in equities and property. These bubbles burst in the late 1980s and early 1990s, with a surge in non-performing loans, and two decades of relative economic stagnation followed.

Japan has not recovered from this episode, so the argument goes, because action was not taken to isolate the losses from the collapse in asset prices and rebuild bank and corporate balance sheets. In the past two decades, Japan has managed only weak economic growth and recently has experienced deflation, leading to declines in nominal GDP. On the basis of these parallels, some commentators argue that China is headed for a slowdown and perhaps even a long period of stagnation.

Despite the similarities, there are many differences between Japan in the 1980s and China in the 2010s. For a start, China's per capita GDP is currently around one-fifth of the US's; Japan was at that level in 1950 and by 1990 had reached 90% of US levels. China's urbanisation rate now is similar to Japan's at the beginning of its expansion, at around 50%, and by the early 1980s Japan's urbanisation was much higher than China's today. These points suggest that in terms of the level of development, China is currently closer to where Japan was when it began its expansion after the Second World War than in the early 1980s. That indicates that China's development has some way to go before it follows a similar path to Japan in the 1980s.

N'Diaye (2010) examines the parallels between China's development in the past 30 years and Japan's between the 1950s and 1980s and points out that there are many differences between the two countries (apart from the level of development), for example the structure of the economy, the system of government and the global environment at the time. He concludes that there are limits to China's export-led growth strategy which is likely to incur resistance from trading partners, especially if it is based on an undervalued exchange rate.

He also concludes that the exchange rate, macroeconomic policies and structural reforms can play a key role in rebalancing the economy towards the non-tradables sector. He considers that the insights are relevant to China and that it can learn from Japan's experience; the differences between the two economies should also work in China's favour and allow it to avoid the path followed by Japan in the past two decades.