Chinese trend growth, part one: The demographic perspective

Craig Botham, Emerging Markets Economist

In the first of our three-part series looking at Chinese trend growth, we examine the country’s demographics, on which we

think observers have become overly negative.

A number of economic arguments are advanced on the basis of the Chinese demographic outlook, but the typical thread

runs as follows:

1. China’s demographic dividend is exhausted

2. There is no room for further capital stock growth

3. Trend growth must therefore decline rapidly from now on

We are not entirely unsympathetic to the reasoning, but we believe bearish sentiment predicated on this thesis is

overdone. There are reasons to expect a declining trend growth rate, and it is true (Chart 1) that the working age

population is in decline, but there are still ways to eke out further labour gains. Urbanisation, for example can transfer

more workers from less productive to more productive industries, and further capital growth will be required to support

this process.

Chart 1: China’s working age population is already in decline

Source: UN, Schroders Economics Group. 11 December 2015

First of all though, we should challenge the perception that China’s growth has been entirely reliant on its population growth. Chart 2 shows the results of analysis from Capital Economics, decomposing Chinese GDP growth over the last 30 years. While it is clear that the increase in the workforce was a powerful growth driver in the 1980s and 90s, it ceased to be particularly important at the start of the 2000s. Far more relevant have been urbanisation (the shift of workers out of agriculture), and the increase in productivity. To support the bear case, we would need to show that these components would suffer as the result of a shrinking workforce. But, at a glance, there seems no strong evidence to support the view that the decline in the working age population should see growth rates collapse. In what follows, we will examine the prospects for further urbanisation and productivity growth, and then project Chart 2 ahead for the next 15 years to reflect our conclusions.

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The importance of being urban

Chart 2 provides some demonstration of the role urbanisation can play in boosting economic growth, but it warrants some discussion. The growth boost comes chiefly (at least, at first) through the transfer of workers from low productivity agriculture to high productivity manufacturing. While data on agriculture versus manufacturing productivity is difficult to obtain, we can approximate the gap by looking at the difference between output-per-worker in the primary and secondary sectors, which amounts to roughly 90,000 yuan, or $14,000. That is, for every worker we transfer from agriculture to manufacturing, we add $14,000 to Chinese GDP. With over 200 million people employed in the primary sector, the potential gains would appear to be huge. Of course, it is unrealistic to assume the entirety of the agricultural workforce will be transferred to factories, if only because the country needs to produce some food. With that in mind, it would be useful to find some way of estimating the limits of urbanisation. Fortunately, China is far from the first country to undergo this process, and so we can turn to history for a guide (Chart 3). In general, an urbanisation ratio of around 80% seems to be the ceiling, though we do find some exceptions. Japan, for example, is over 90% urban. However, this is likely due to factors unique to Japan rather than a likely end point for China, so we will focus on other, more relevant, examples. Chart 3 shows the experience of the US (which has a similar geographical scale to China) and Korea (which provides the most recent example), both of which more or less topped out at 80%, so let us assume the same applies to China. Beyond this end point, it would also be helpful to estimate how rapidly the process will occur, as this has further growth implications. We have rebased Chart 3 such that each country starts from the same level of urbanisation, to compare relative progress. Evidently, the US urbanised much more slowly than did Korea, and without looking at the Chinese data one might expect China to be similar, given that Korea is far more compact. Yet it turns out that China has so far followed the Korean path very closely. We suspect this at least partially reflects the advances in transportation and telecommunications technology since America’s urbanisation process. China’s own urbanisation plan calls for an annual 0.9% urbanisation rate, lower than the Korean experience would imply, so we adopt this as a cautious estimate. It is not implausible that China would face greater difficulties over time given the vastly larger land area relative to Korea. Charts 3 & 4: The limits of urbanisation (as implied by history, and by Lewis)

Source: Thomson Datastream, IMF (2013), Schroders Economics Group. 11 December 2015

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However, this is not the only consideration. Another limiting factor for urbanisation’s growth contribution is the so-called Lewis Turning Point. At some point during the urbanisation process, the agricultural sector cannot lose further workers to the rest of the economy without experiencing a labour shortage. Wages then climb in both agriculture and industry, outpacing productivity and so squeezing industrial profits and investment. This necessitates a change in the growth model, requiring a shift to a greater reliance on productivity growth rather than amassing production inputs. This is also the point at which growth likely slows markedly, and is the nub of many of the bear arguments. Chart 4 shows the estimates from a 2013 International Monetary Fund (IMF) paper

1 for when this turning point will be

reached in China. The authors estimate surplus labour will be exhausted between 2020 and 2025, with the exact date depending on which scenario plays out. Boosting labour force participation (currently far below the average elsewhere for the over 50s) would push the fateful date back to 2025, for example. So, we should expect to see a marked slowdown in Chinese trend growth by this time. Interestingly, this coincides with the time at which the Korean urbanisation path would also imply a slowdown.

One final ingredient needed before we can model trend GDP growth is some assumption for labour productivity growth; a major driver for GDP growth in Chart 2. Using data from the St Louis Federal Reserve on capital stock and labour productivity, China today resembles Korea in the late 1990s in terms of its capital stock per worker. We therefore assume China follows the Korean path and sees a gradual reduction in labour productivity gains, an assumption which imposes the Lewis Turning Point we discussed above and implicitly includes a reduction in the rate of capital accumulation. Combining these assumptions, we have a forecast for Chinese trend growth based on demographic considerations (Chart 5). Chart 5: Decomposed Chinese trend growth forecast

Source: Thomson Datastream, NBS, Schroders Economics Group. 11 December 2015. Please note: LFP stands for labour force participation

We also model a scenario in which China slowly raises its labour force participation rate to Korean levels over the 15-year period. Labour force participation rates are reasonably high in China as a whole, but are below Korean and Western levels for the over 50s. China’s average participation rate for this age group is around 30% compared to around 70% in Korea; convergence would see an addition of around 90 million workers, or 10% of the existing workforce. There may be a range of reasons for this disparity. We would speculate, for example, that it is harder to employ older workers in an economy with fewer service sector (and less physically demanding) jobs. Hence we model only a gradual and incomplete convergence to Korean participation rates, as we do not see the two economies becoming structurally identical in the timeframe. In the “no LFP change” scenario, trend growth is estimated at around 5.7% today and forecast to fall to 3.4% by 2030. While undeniably a slowdown, it is probably not the apocalyptic scenario often imagined. Furthermore, when we look at the breakdown, it is clear that the declining population is not a significant driver until the tail end of the period, when i t shaves around 0.5 percentage points from the growth rate. The model also suggests that reforms aimed at boosting labour force participation would balance out the declining population until 2029/2030, so a declining population represents little threat to Chinese growth in the medium term. Instead, the real challenge lies in the falling productivity growth, which accounts for almost all the fall in total GDP growth. Unfortunately for China, there are few policy tools available to fend off this decline, which is an inevitable end point for any emerging market economy experiencing “catch up” growth. We will examine this further in a future Talking Point piece.

1 Das, M., N’Diaye, P. “Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point?” IMF Working Paper 13/26

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No crash landing ahead but a much slower China inevitable

One question that arises from this is whether China is now due a hard landing. After all, GDP growth, officially on track for 6.9% in 2015, is far above trend, and has been for some time. A significant correction is apparently needed to bring activity into line, so perhaps the bears are right after all? The problem for the bear argument now, however, is that no self respecting doom-monger would accept the official GDP number of ~7% growth. Depending on who you talk to, some would have it as low as 2% (and possibly even lower). But in that case, the correction has already happened, and we should expect an upturn in Chinese growth to return to a trend growth number of over 5%. Our view would be that Chinese growth is somewhat overstated, though chiefly through statistical errors and perhaps a tendency to round up, instead of down. Capital Economics, for example, estimate that incorrect calculation of the GDP deflator might be overstating real GDP growth by 1-2% in the first half of 2015 - which brings the true growth number much closer to our estimate of trend growth. Aside from this, there are few of the usual signs of an economy growing above trend; inflation pressures are extremely muted, and the Producer Price Index (PPI) is in fact in deflationary territory. IMF analysis of the Chinese output gap estimates a negative gap under the usual methodology (i.e. the economy is below trend), but a positive gap when using a “credit augmented” measure

2, and this is

where we see the risk. So, by traditional metrics, China is below trend in that spare capacity is rampant. But this spare capacity has been achieved through above-trend credit and investment growth which has to now unwind. We include a “China hard landing” risk scenario in our economic forecasts, but it arises from financial instabilities rather than an overheating economy. The high and growing level of indebtedness and the opacity of balance sheets create concerns over lurking asset quality issues beyond those officially stated by banks. A financial crisis would have the potential to take growth significantly below trend, and could, as in the West, see a prolonged period of below-trend growth as the rubble is cleared. But again, this is not a result of the usual overheating typical of the end of a business cycle. Equally, however, we would caution against looking at Chart 5 and expecting a smooth ride for China. It would be extremely unusual for the economy to undergo such an adjustment without some cyclical volatility, and a recession at some point seems a certainty. Further, investors will need to get used to a world in which China in all likelihood posts a lower growth number every year for at least a decade, depending on the speed of adjustment. Rather than taking comfort from government stimulus, we would become concerned if policymakers became modern day King Canutes, trying to halt, in their case, a receding tide by unleashing stimulus after stimulus. The more adjustment is deferred, the more painful it will ultimately prove, and there is no policy that can successfully prevent this kind of structural slowdown. To our minds, every attempt to hold the growth rate above trend increases the risk of crisis, notwithstanding the measurement errors we mentioned above. However, importantly this inexorable downward grind is due not to the population decline, but to slowing productivity growth, a topic we plan to explore in a later note.

2 Maliszewski, W., Longmei, Z. “China’s Growth: Can Goldilocks Outgrow Bears?” IMF Working Paper 15/113

Chinese trend growth, part two: Productivity growth – the Solow perspective

Craig Botham, Emerging Markets Economist In this second instalment of our analysis of Chinese trend growth, we pick up the theme mentioned towards the end of our last note. In that first note, we looked at what a declining population means for China’s growth and concluded that the impact was minimal, and outstripped by the effects of urbanisation but even more by the effects of labour productivity growth. Here, we examine productivity growth in more detail. For the workforce, productivity can be boosted by the simple expedient of adding more capital (while technological progress is also an important driver particularly in more advanced economies). To give a hugely simplified example, more machines mean workers can produce more goods. This then raises the question of how much capital can be added, and for what return. Clearly, at some point the addition of more machines in a factory would not raise the output per worker, because each worker would already be fully occupied utilising the existing machinery. We might then suppose there is some optimum level of capital per worker, beyond which it does not pay to invest in additional units. This is the starting point of the Solow growth model. In the Solow growth model, economic growth is driven by the accumulation of physical capital until this optimum level of capital per worker, the so-called “steady state”, is reached. The steady state itself is determined by labour force growth, the savings rate, and the rate of depreciation. The model predicts more rapid growth when the level of physical capital per capita is low, something often referred to as “catch up” growth. When the steady state is reached, growth in per capita incomes is determined entirely by technological progress. All things being equal, therefore, the model predicts that emerging markets should grow faster than developed markets, and this is generally what we see. So what does the model predict for China? Chart 1: Capital stocks per worker in selected economies

Source: Federal Reserve of St Louis, World Bank, Schroders Economics Group.

Chart 1 shows the estimated capital stock per worker in China, South Korea and the US. In the simplest form of the Solow model, we would assume China’s convergence over time with the US, which implies that there is a great deal of

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investment left to go given a gap of over $90,000 per head. Yet it is possible that the US is the wrong example to choose for China; the countries have different savings rates in both physical and human capital, so convergence is not assured. We might instead look at Korea, which bears greater similarities to China in a number of ways, but importantly this includes the behaviour of fertility and saving, rendering it a more likely point for convergence. It turns out that the scope for catch up is still significant, so again Solow’s model still implies a growth rate above that seen in developed markets for as long as it takes to close the gap. We would also argue that the disparity in capital stocks demonstrates very clearly that China has not exhausted her investment opportunities, as some claim. The next question to ask then is how long this catch up process is likely to take. Given that we would like to use the results of this analysis to provide estimates of trend growth, using growth forecasts to predict the path of investment would be rather circular. Instead, given that we have identified Korea as a likely candidate for Chinese convergence, let us look at the Korean experience. Chart 2 shows the accumulation of capital stock in Korea and China, with the timeline beginning when the per capita capital stock stood at approximately $2,500. The thirty or so years following this point seem to have generated similar experiences in both countries, so convergence looks a plausible theory. This implies that in around 15 years, China will be close to Korea’s current level of capital per worker. Of course, Korea’s path includes a rather large bump in the form of the Asian financial crisis, and assuming identical timelines would place China just two years from that moment at most. This is a much cited worry; that no economy has invested at the rate China has without hitting some crisis as a result. While we would not rule this out, we would note that the Korean experience was in large part due to a high reliance on foreign capital which rendered the economy susceptible to a “sudden stop”. China, by contrast, has almost entirely self-funded its investment. This is not to say there are no risks, there are many, but there are limits to what history can tell us about the future. With this caveat in mind, we will look to extrapolate the likely path of Chinese investment growth from the current similarity to Korea’s. Assuming convergence with Korea by 2030 implies growth in the capital stock of between 6.7% and 7.0% for the next 15 years, declining to the lower bound over time. Chart 2: Capital accumulation in China and Korea

Source: Federal Reserve of St Louis, World Bank, Schroders Economics Group. 31 December 2015

At this point, apologetically, we return once more to Solow, but this time to the growth accounting approach he did much to foster. Under this approach, growth can be decomposed into three main elements: growth in the labour force, growth in the capital stock, and growth in what is commonly called total factor productivity (TFP); essentially the efficiency with which we combine labour and capital, and which is boosted by technological progress. So to implement this approach to estimate future Chinese growth, we will need estimates of each component. From our analysis above, we have obtained a figure (6.94%) for growth in the capital stock, and the UN produces regular working age population forecasts, which gives a number for labour force growth. So all that remains is to obtain a figure for TFP growth. This is likely the most contentious part of our analysis given the difficulties in measuring TFP. We draw on data from the Penn World Table in what follows. The most recent data suggest TFP growth in China was around 3% on average in 2005-10, but this is distorted by the impact of the crisis; removing that effect leaves TFP growth looking more like 2% annually. For the US, it looks to be around 1%, and in Korea, roughly the same – though the series is volatile. It seems

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unlikely that China will be able to maintain higher TFP growth rates indefinitely – much of the larger gains (some years show TFP growth of 6%+) came earlier on, possibly reflecting the massive boost to productivity from adopting radically more advanced technologies as the country industrialised. As the level of technology converges with that in Korea or the US, TFP growth rates should do the same. Consequently, the contribution of TFP growth to overall GDP growth should diminish over time. While we have so far framed TFP entirely in terms of technology, other factors can also impact it. Recall that we described TFP as the efficiency with which inputs are combined into outputs. While technology undoubtedly plays a large role in this, government regulation also has an effect particularly give its impact on the efficiency of resource allocation. In this simple model, the resources in question are labour and capital. On labour, restrictions on labour mobility (in the form of the hukou registration system) will reduce efficiency and hinder TFP. On capital, a system under which credit is

directed by a series of quotas and mandated lending is also likely to lead to inefficient allocation, as is evidenced by the excess capacity in China’s heavy industry and property sectors. Reforms on both fronts (as are planned) can therefore boost TFP; the success or failure of market friendly reforms could have significant growth consequences. In Chart 3, we combine our estimates for labour and capital stock growth with a number of TFP scenarios. In our best case, China manages to successfully implement market-based reforms, such that although TFP drops from the current 2% level in 2020, it continues to see growth in line with America’s TFP of around 1% per annum. We assume that China continues to benefit from innovation both domestically and globally, with reforms enabling the full integration of technology on a par with the rate of adoption elsewhere. Before readers scoff at this assumption, we would refer to China’s experience in e-commerce and consumer telecommunications, where in many respects they have equalled or even surpassed Western counterparts. Alongside this, in the best case scenario, is the assumption that China manages to boost labour force participation, particularly among the older segment (50-64) of its workforce. We discussed this in more detail in the first part of this series, but essentially participation amongst this segment is far below that in the West or Korea. A gradual (but not complete) catch up on this front helps cancel out the effects of a declining workforce. Chart 3: Predictions for Chinese growth based on a Solow model approach

Source: Schroders’ Economics Group. 4 January 2016

The other scenarios are versions of our best case, but dropping one or more assumptions – no labour force participation increase, no reform progress, or both. The no reform assumption reduces TFP growth to 1% in the first five-year window, and 0% thereafter, with significant GDP growth consequences. This gives us a range of potential trend growth numbers. At one end of the scale, this provides our best case numbers of 5.7% trend growth for the next five years which then drops to 4.4% by 2030. In the worst case, trend growth today is only 4.4%, and falls to 3.1% by the final period. The chief driver of the differences lies in the TFP assumptions we have made, so radical reforms, technological breakthroughs, or political crisis all present obvious risks to the forecast. Overall though, it is encouraging to see a similar range of predictions as generated by our previous work looking at the demographic implications for trend growth. Once again, we have a trend growth number some way below the official GDP number. So given that GDP tends to revert to trend, this presumably implies a significant correction, perhaps even a hard landing to come. But as we have

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said, the official numbers are somewhat in doubt. With apologies to those who read our last note, we reproduce the argument below. Depending on who you talk to, some would have Chinese growth as low as 2% (and possibly even lower). But in that case, the correction has already happened, and we should expect an upturn in Chinese growth to return to a trend growth number of over 5%. Our view would be that Chinese growth is somewhat overstated, though chiefly through statistical errors and perhaps a tendency to round up, instead of down. Capital Economics, for example, estimate that incorrect calculation of the GDP deflator might be overstating real GDP growth by 1-2% in the first half of 2015 - which brings the true growth number much closer to our estimate of trend growth. Aside from this, there are few of the usual signs of an economy growing above trend; inflation pressures are extremely muted, and the Producer Price Index (PPI) is in fact in deflationary territory. Analysis from the International Monetary Fund (IMF) of the Chinese output gap, estimates a negative gap under the usual methodology (i.e. the economy is below trend), but a positive gap when using a “credit augmented” measure

1, and this is where we see the risk. So, by traditional metrics, China is below trend, in that spare

capacity is rampant. But this spare capacity has been achieved through above-trend credit and investment growth which has to now unwind. We include a “China hard landing” risk scenario in our economic forecasts, but it arises from financial instabilities rather than an overheating economy. The high and growing level of indebtedness and the opacity of balance sheets create concerns over lurking asset quality issues beyond those officially stated by banks. A financial crisis would have the potential to take growth significantly below trend, and could, as in the West, see a prolonged period of below-trend growth as the rubble is cleared. But again, this is not a result of the usual overheating typical of the end of a business cycle Still, it would be extremely unusual for the economy to undergo such an adjustment without some cyclical volatility, and a recession at some point seems a certainty. Further, investors will need to get used to a world in which China in all likelihood posts a lower growth number every year for at least a decade, depending on the speed of adjustment. Rather than taking comfort from government stimulus, we would become concerned if policymakers became modern day King Canutes, trying to halt, in their case, a receding tide by unleashing stimulus after stimulus. The more adjustment is deferred, the more painful it will ultimately prove, and there is no policy that can successfully prevent this kind of structural slowdown. To our minds, every attempt to hold the growth rate above trend increases the risk of crisis, notwithstanding the measurement errors we mentioned above. One other implication of our work here is that China still has significant scope for capital investment. Yet media reports of Chinese spare capacity are almost as abundant as the country’s steel production, so how can the two be compatible – is this just extreme naiveté on our part? Our third and final instalment will examine where we think this capital could go, and the potential for consumption growth and service sector development in the new China.

1 Maliszewski, W., Longmei, Z. “China’s Growth: Can Goldilocks Outgrow Bears?” IMF Working Paper 15/113

Chinese trend growth, part three: The future for new China

Craig Botham, Emerging Markets Economist So far in this series of notes on China, we have examined the prospects for Chinese trend growth, given the demographic outlook, planned urbanisation, and the scope for investment. In this third and final note, we address the issue of where this investment can go, and whether there is macroeconomic support for the planned transition to the new, consumption- led, China. In general, are the themes identified in our first two notes: demographics and capital catch up, supportive of the hopes that China can find new drivers of growth? One argument we have heard advanced in favour of a bearish stance on China is that investment cannot continue to drive growth because there is nothing left to invest in. That is, China is now entering the “bridges to nowhere” stage of investment spending, as seen in Japan and elsewhere. We do not agree with this argument unconditionally. While it is true that China has invested huge amounts of GDP, and spare capacity problems in certain industries (along with “ghost cities”) suggest overinvestment has occurred in some areas, we saw in the previous paper in this series that GDP per capita remains far behind the US or South Korean levels. There must be some gaps somewhere. Starting at a simple level, Chart 1 shows some data on basic infrastructure across China. The data is available at a provincial level, which is then grouped by region, each of which is generally recognised to be at a different level of development. The eastern provinces, for example, are most closely tied to international trade and have seen the highest growth in GDP and income, and higher urbanisation rates. Chart 1: Basic infrastructure needs almost met, but some gaps remain

Source: NBS, Schroders Economics Group. 24 September 2015

Basic needs are broadly met across the provinces. Access to sanitation and clean water (not shown), for example, is near universal in urban areas. But there are some gaps in provision of other basics. Access to gas, for example, is clearly much higher on average in the eastern provinces than in the west. Road density is also much higher in the east than west. At this stage we are not attempting to make quantitative assessments of the amount of investment needed; this serves only as an illustration that investment is not “done” in China. However, it will take more than catch up in gas provision and road density to generate meaningful scope for investment growth. One of the big drivers of investment and hence economic growth in China has been manufacturing, establishing the

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country as a workshop to the world for the first decade of this century. But the problem of spare capacity in some industries and the negative producer price inflation (PPI, currently running at close to -6% a year) coupled with stagnant global trade would suggest further gains here are likely to be limited. Drawing on data from a paper by Yanrui Wu

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have calculated current manufacturing capital stock for each Chinese province, and again grouped by region (Chart 2). The intention here is to assess whether there is scope for investment to bring other regions of China in line with the more developed eastern provinces. We look at regional averages rather than aiming for convergence to the province with the highest capital per capita, because we assume that manufacturing hubs will likely cross provincial lines, and that a province like Hubei has such a high level of capital because it is supplied with other resources by neighbouring provinces. In much the same way that not every British city can be London, or every American city New York, not every Chinese province can be Hubei or Jiangsu. Chart 2: Manufacturing capital at similar levels across each region

Source: Wu (2009), NBS, Schroders Economics Group. 24 September 2015

As Chart 2 shows, regional averages for manufacturing capital per capita do not actually vary by much. So there is perhaps something to the argument that investment here, at least, has run its course. This is not to say that China can no longer invest in manufacturing; some amount of investment will be needed to maintain the same level of capital stock per person thanks to population growth (for now) and depreciation, and to keep up with changes in technology. There is also some scope for China to move up the value chain in manufacturing, producing higher technology goods to compete with developed market exporters. But the period of rapid, “catch up” growth in manufacturing may well be over. Where the real gap lies between China and those economies with much larger capital stocks is the service sector (Chart 3). While it is tempting to think of services as meaning things like tourism, finance and retail, none of which seem particularly capital heavy, it also incorporates telecoms, transport, and other infrastructure. Again, visitors to the major cities like Beijing and Shanghai may think that even here the Chinese have done all they can; the situation is very different as we move away from the eastern provinces. The right hand panel of Chart 3 shows that at the national level China still lags Korea in both high and low technology. Even in the largest cities, the level of pollution and traffic alone implies that further investment in public transport would not go to waste. Education and healthcare, too, are ripe for further investment, and will be essential to creating the human capital China will need if it is to compete in the highest value-added industries.

1 Wu, Y “China’s Capital Stock Series by Region and Sector” University of Western Australia, Discussion paper 09.02 (2009)

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Chart 3: Still scope for catch up in services

Source: Wu (2009), NBS, World Bank, Schroders Economics Group. 14 October 2015

Arguably for service sector growth (and the associated investment) we need to see a growing consumer base. One way to achieve this is to boost incomes through economic growth, but for an emerging market like China, incomes can also be boosted through urbanisation. We went through this in more detail in our first note in this series, and to avoid repetition interested readers may want to read that paper for a more complete discussion. Briefly though, the transfer of workers from the rural to the urban sector can be a powerful driver of growth given much higher productivity in the urban sector. Given that pay is (generally) linked to productivity, this process also sees an increase in incomes for the workers involved. As Chart 4 shows, urban dwellers typically have more than double the income of their rural counterparts. Furthermore, the majority of this additional income translates into additional expenditures, with urban dwellers spending 2-3 times as much as those in rural areas. Based on current income levels, if China were to achieve 80% urbanisation today (the developed world average), this alone would add consumption worth 3% of GDP. Chart 4: The impact of urbanisation on income and spending

Source: NBS, Schroders Economics Group. 24 September 2015

Obviously, China will not achieve this level overnight. Happily, however, we have already conducted analysis of a likely urbanisation and implied trend growth path (see the first two notes in this series). We can take advantage of this to calculate a probable path for consumption (Chart 5). We decompose growth in consumption into the contributions from urbanisation, population growth and income growth. Urbanisation is assumed to proceed at a rate of 0.9% per annum, as laid out in the government’s urbanisation plan. Korea managed to urbanise more rapidly, so we do not feel overly naïve in accepting a government target on this occasion. Our numbers for population growth are based on UN forecasts, and we assume that incomes grow at the same rate as labour productivity (based on an assumption around the growth rate of the capital stock, discussed in our first paper). We make no change to the propensity to consume (the share of income consumed rather than saved), though given the current high saving rate in China one would expect this to increase over time – an upside risk to our forecast. As with our trend growth forecast, much of the boost to consumption is expected to come from growing household incomes. Yet demographics also prove supportive for most of the period. Urbanisation adds around 1% to consumption growth each year, with a further 1% added by population growth for the first five years, though this dwindles to become negative by 2029. Overall, consumption trend growth is higher than trend GDP growth across the period, picking up the slack from weaker investment growth. With household consumption accounting for just over 36% of GDP, compared to roughly 44% for investment, it certainly seems possible for consumption to take over as a driver of growth.

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Chart 5: Household consumption has potential as a growth driver

Source: NBS, Thomson Datastream, Schroders Economics Group. 13 October 2015 Conclusion

What, then, should we take away from all of this about China’s future? We think a few key themes are as follows:

1. Whether considered from a demographic or capital accumulation perspective, trend growth in China is probably around 5.5%, and will decline to 3 to 4% over the next 15 years. Reforms and other changes can make some difference to this number but the margin is typically less than an additional percentage point.

2. A declining workforce is not fatal to Chinese growth: gains in labour productivity, consistent with a more capital intense economy, easily outweigh the small drag on activity, and drive a growth rate which continues to exceed that of any developed market.

3. There is ample scope for further capital accumulation, as is evident from a comparison of China and the US, or of China and Korea. Most of these investment opportunities now lie in the services sector. But the biggest catch up gains in investment are behind us.

4. When considering GDP from an expenditure side, it is clear that consumption has the potential to be the main growth driver.

Of course, these are all long-term themes, and do not preclude a crisis in the short term. Like others, we are concerned about the buildup of debt in China and see the financial system as the likely source of any hard landing. But we see little evidence that the economy is overheating, looking at the data and at our estimates of trend growth. In addition, a financial crisis need not throw China completely off track – a reversion to trend should be possible.

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