To continue growing, China will have to work a lot smarter

Productivity is the growth driver that will determine whether the optimists or pessimists are right when it comes to China's outlook

PUBLISHED : Friday, 07 February, 2014, 5:17am
UPDATED : Friday, 07 February, 2014, 12:54pm

As ever, there are two views about the outlook for the mainland's economy. As usual they could hardly be more different.

Everyone acknowledges that its economic growth has slowed, decelerating from double-digit rates as recently as 2010 to a relatively modest 7.7 per cent last year.

But the optimists believe that's about as low as the growth rate is likely to fall, and that the mainland will successfully maintain growth of around 7.5 per cent for the rest of this decade.

The pessimists, in contrast, argue that the slowdown has barely begun. They expect the annual growth rate to slump well below 5 per cent over the coming years.

Both camps recognise that China's economy needs to reform and rebalance, becoming a lot less dependent on credit-fuelled investment by local governments and state industries and a good deal more reliant on private service sector businesses.

Where they diverge is on how smoothly reform will proceed, and the impact rebalancing will have on growth.

The optimists believe that the planned opening of state-dominated areas of the economy to the private sector, coupled with financial liberalisation, will release a pent-up wave of productivity growth.

That boost, they say, should easily offset any short-term pain caused by the elimination of excess capacity in China's over-invested heavy industries.

The pessimists argue that just as the mainland's recent rapid expansion has been driven by increasing leverage, so the deleveraging process must lead to slower growth in the future. It's in the maths, they insist.

To get an idea who is closer to the truth, it helps to borrow an old analogy.

If you run a sausage factory, there are three ways you can increase your output of sausages. You can employ more staff to make them. You can invest in new sausage-making-machinery.

Or you can use the staff and machines that you already have more efficiently.

In short, you can add labour, or human capital. You can add physical capital. Or you can get smarter about how you work.

Measuring the first two inputs is simple. Measuring the third driver of growth is very difficult. Essentially it's what produces the growth you can't account for either by adding workers or boosting investment. Economists call it total factor productivity, or TFP.

In China, very little growth in recent years has been driven by adding labour. As the first chart shows, almost all has been propelled by capital and TFP growth, with the lion's share driven by investment in physical capital.

Ominously, the contribution of TFP growth has been declining, from an average of 4 percentage points between 2001 and 2008, to just 2.4 percentage points from 2009 to 2012, according to the International Monetary Fund. Meanwhile, the contribution from investment has grown.

If China is successfully to wean itself off excessive investment, the contribution of additional physical capital to economic growth will need to fall by between a third and half.

The IMF's researchers believe that some of this decline can be offset as reform and deregulation boost the contribution of TFP growth to overall growth to around 3.3 per cent a year.

That would imply growth of around 6 per cent a year over the next decade or so as China gets smarter, partially compensating for slower investment.

Not everyone agrees that TFP growth can pick up the slack, however. One projection by the Asian Development Bank sees TFP growth not accelerating, but slowing to just 1.7 per cent over the rest of this decade (see the second chart).

If the ADB's research is right, Chinese growth could indeed fall below 5 per cent a year by the end of this decade. It all depends on whether China can manage to work smarter or not.