The Reality Of China's Economic Slowdown

Yuwa Hedrick-Wong

The slowdown of the Chinese economy is not a cyclical down turn. It is part of a deep and complicated transition the outcome of which will shape the future of China, and with it, the rest of the world.

The reality of China’s economic slowdown, stripped to the bare essential, has to do with the diminishing effectiveness of several key contributors to the productivity growth that fueled the country's spectacular economic expansion in the previous three decades. These include the rising quality and quantity of the labor force, the more efficient allocation of resources and investment capital, the rapid upgrading of technology, as well as sustained high export growth.

When economic reform started the late 1970s, the vast majority of China’s labor force toiled in agriculture, using tools and methods not much different from many centuries back. Even though basic literacy and education was vigorously promoted under socialism, only 2% of young adults had any post-secondary education. In the subsequent three decades, hundreds of millions of farm workers moved from villages to factories and urban construction sites, trained to use modern equipment and machinery. By 2016, about two-thirds of the population are urban, and over 30% of young adults are university educated. Over the same time period, the One Child policy also produced a massive demographic dividend with a rising ratio of working age to total population, according to data from China's National Bureau of Statistics. The net effect was a growing and increasingly productive labor force.

But the demographic dividend ended in 2012, when the ratio of working age to total population peaked, ironically caused by the very same One Child policy that produced the demographic dividend, amplified by the rising longevity of the population. The pace of improvement in the labor force’s education and skill level has also slowed. While the better skilled and more mobile labor force will continue to contribute to productivity growth, it is impossible to maintain the pace of the past.

A second major contributor to productivity was the transition from a top down system of resource allocation to a price-based market economy. This was crucially important in enabling the emergence and expansion of a private sector, which could be guided by changing price signals in seeking out new market and investment opportunities. In recent years, investment by the private sector grew to account for two-thirds of the total. The gains in allocative efficiency has been absolutely massive, as described by Nicholas R. Lardy in Market Over Mao: The Rise of Private Business in China. However, the transition to market-driven prices is by and large done (notable exceptions are the banking and petroleum sectors), and its contribution to further productivity gains will be unavoidably smaller.

These two contributors to productivity gains were powerfully complemented by China’s ability to rapidly upgrade its technology. Foreign direct investment (FDI) played a major role in this regard. FDI inflows typically come with more advanced technology as well as technical and management knowhow. Foreign multinationals have been a critical conduit in technology transfer (willingly or not as the case may be). However, as China’s technological capability approaches that of the advanced economies, catching up is becoming a lot harder.

Finally, the Chinese economy benefited hugely from its extraordinarily successful exports, which grew by an average of 17% a year for three decades according to IMF data, an astonishing record. This propelled China from a bit player to becoming the largest exporter in the world today. As the largest exporter in the world, however, China’s export cannot grow much faster than the global economy. To try to do so China will have to take market shares away from other exporters continuously, which will be economically challenging and politically disastrous. In the coming decade and beyond, China will have to contend with low single digit growth rates in export.

China’s economic slowdown is therefore both natural and desirable. It is natural because most of the lower hanging fruits such as price liberalization and low value-added labor-intensive exports have already been harvested. And it is desirable because the slowdown necessitates a transition to higher value-added production, rising wages, stronger domestic consumption, and a generally improving living standard. Implicit in this economic transition is a potential quantity – quality trade off: lower headline growth rate for the economy but higher quality of growth for the society.

China is not there yet. To complete the transition successfully China has to abandon some old habits and take risks on embarking on some new ones. While China’s rapid urbanization has created a fertile environment for private entrepreneurs, especially in the service sector; they need to be supported by having better access to more investment capital. The practice of banking and finance will have to change. While China is poised to create mega metropolitan regions consisting of more than a hundred million population each, how the 250 million plus migrant population without an urban residency permit are to be absorbed and meaningfully integrated into China’s urban society will affect the outcome. Social policies on residency control, access to public services, and social welfare provision will have to change. There are many challenges ahead.

For now, however, its a mistake to fixate on China’s GDP growth rates, which is to miss the bigger picture altogether. In 2010, 10% real GDP growth added $606 billion to the economy. In 2017, however, 6% growth added $1,202 billion, double the amount of the 10% growth in 2010. Even though India’s real GDP growth rates exceeded China’s in recent years, the fact of the matter is that in any two years period since 2010 what China added to its GDP is bigger than the entire Indian GDP. As a result, the gap between the Chinese and the Indian economy is getting bigger, not smaller. In spite of China’s economic slowdown, China’s global economic reach and influence is set to expand, and that’s the bigger picture that we need to watch.