China's 'new normal' growth is still far too optimistic

Investment-fuelled economy has its limits and even shift to consumption as economic driver won't deliver big results, if precedent is any guide

PUBLISHED : Tuesday, 09 October, 2012, 12:00am
UPDATED : Tuesday, 09 October, 2012, 3:14am

Everyone is talking about "the new normal" in Chinese growth.

What they mean by this is that the softening we are seeing now in China's economy is not just a cyclical dip, but a structural down-shift to a slower growth path.

As the World Bank's former mission chief in Beijing, Pieter Bottelier, put it back in back in July: "The heady days of double-digit economic growth in China are almost certainly over."

Plenty of other economists agree. In its latest economic outlook released today, the International Monetary Fund forecasts that China's economy will slow to just 7.8 per cent this year and 8.2 per cent next year, compared with an average growth rate of 10.6 per cent over the last 10 years.

A slowdown has long been expected. In recent years, China's growth has been propelled overwhelmingly by investment, which in 2011 made up nearly half of the country's gross domestic product.

Investment-driven growth cannot go on at such a pace. To see why, imagine a town A which grows apples, and a distant town B whose main product is oranges.

If you invest in building a highway between the two where none has existed before, A's townspeople can now sell their apples to consumers in B, and B's inhabitants can truck oranges to A to meet the demand there.

By building the road you have doubled the size of each town's potential market, providing a major boost to the overall economy.

But building a second road parallel to the first doesn't have anything like the same impact. It may relieve the traffic a bit. But the economic boost will be small at best. And investing in a third road - as in some places in China - simply leaves you with construction debts to service.

In other words, the productivity boost produced by investment in fixed assets like roads tends to fall over time, which is why investment-driven growth has to slow.

That's why there is so much talk about consumption taking over as China's main engine of economic development, with a downshift in growth rates to a "new normal" of 7 to 8 per cent rather than the 10 per cent of recent years.

But history indicates that to expect even 7 to 8 per cent growth may be too optimistic.

After all, China's growth splurge of the last few decades is hardly unique. There are plenty of precedents in history. Between 1950 and 1970 Japan underwent two decades of near double-digit average annual growth. And, for 20 years from the late 1950s Brazil saw similarly rapid growth rates.

Tracking down reliable data that goes back so far is tricky. To make up the chart below I've used long-term figures compiled by the late Angus Maddison, emeritus professor of economics at the University of Groningen.

Maddison's numbers refer to gross domestic product adjusted for differences in purchasing power. And to smooth out some of the cyclical noise and make the structural trends clearer, I've calculated five-year moving averages for real, inflation-adjusted growth.

I've taken the start date of Brazil's data series as the fall of the Getúlio Vargas dictatorship in 1945.

Japan's starts in 1950, when the Korean war helped kick-start Japan's economic recovery. And China's starts in 1979, with the beginning of Deng Xiaoping's economic reforms.

As you can see, both Brazil and Japan saw long periods of rapid expansion - between 5 per cent and 12 per cent on this measure - before growth tailed off, sinking below 5 per cent. (The Soviet Union showed a similar growth trajectory.)

Given that China's data series on this chart ends in 2008, if the pattern holds China will manage just a couple of more years with growth of 7 per cent or more, before its trend rate of GDP expansion drops below the 5 per cent level.

In short, if history is any guide, economists' expectations China's "new normal" are far too optimistic.