If China can fire on all cylinders, a revival of the productivity cycle is attainable
With the ambition of turning China into a global leader in technology, the government has spent significant resources in R&D in recent years, narrowing the gap between China and the US, in per-GDP R&D spending, substantially as a result.
In the last update of the column, we looked back at China’s 40 years of economic development and discussed three distinct phrases of economic transformation.
That analysis dissected China’s growth pattern from a demand angle. But in fact, traditional economic theories on long-run growth tends to focus more on supply-side drivers.
According to the latter, China’s extraordinary economic success over the past four decades was a result of a large demographic dividend – fast population growth, rural-to-urban labour migration and human capital enhancement – and rapid capital formation.
Our model indeed suggests that these “factor inputs” have accounted for between 60 and 90 per cent of trend growth over the past 40 years.
However, as China’s population ages and capital formation slows, the growth model that relies on factor inputs has become increasingly unattainable.
Take labour as an example, China’s working age population peaked in 2011 and has since fallen by over 2 percentage points.
The United Nation (UN) projects the ratio will decline further in the coming decades to circa 60 per cent, a level similar to that of the US in 2050s. This means that the growth contribution from labour, excluding human capital (such as skills and knowledge), should continue to ebb.
Turning to capital. While the outlook is not as dim, the chance of it picking up the slack from labour is slim. This is because China’s investment share of GDP has already peaked, and should continue declining, as the economy rebalances away from investment towards consumption.
It implies capital formation should also be a diminishing source of growth in the coming decades.
That leaves total factor productivity (TFP) as the only remaining source of potential growth. While notoriously difficult to generate, Chinese leaders appear to be determined to rise to the challenge to explore this avenue.
At last year’s Communist Party Congress, President Xi Jinping was adamant China needs to make a transition from pursuing the speed of growth to the quality of growth.
This implies that productivity-enhancing reforms should take precedence over stimuli that are designed to purely pop up short-term economic activities.
But can China achieve the unachievable by others, and truly turn things around. And if so, where will TFP growth come from?
We think it stands a chance, and growth can be generated from three sources.
● First, the level of human capital has scope to increase further, despite the number of workers may be growing at a slower, or even negative, pace.
Proxied by the average years of schooling and returns on education, China’s human capital in 2014 was only at the level of the US in the 1950s. While this gap has narrowed substantially in recent decades, the potential for further catch up – on both education attainment and the quality of education – remains large.
● Second, urbanisation should continue to drive productivity growth. Over the past 40 years, urbanisation has brought almost 300 million migrant workers from the rural sector to urban cities. Such a shift in the labour force – from the low-productivity primary sector to the high-productivity manufacturing sector – was a critical source of productivity gains for China.
Going forward, this trend should continue as the country still has over 40 per cent of its population living in the countryside and almost 30 per cent of its workers employed by the primary sector.
The UN projects that China’s urbanisation rate will reach 76 per cent by 2050, from 57 per cent currently, implying a continued migration of labour from farming to non-farming employment in the decades ahead.
● Finally, continued economic reforms will generate productivity growth, via two channels. The first is by solving China’s legacy problems in the corporate sector – closing down the zombie companies, cutting industrial overcapacities, restructuring the state-owned enterprises.
A recent IMF research shows that a successful implementation of these reforms could add 0.5 percentage points per annum to total productivity growth.
If China can also succeed in carrying out its industry-upgrading policies, entailed in Manufacturing 2025, then a whole percentage point of TFP growth can quality be added to the economy.
The second source is via reform-driven innovation and technology improvement. With the ambition of turning China into a global leader in technology, the government has spent significant resources in research and development (R&D) in recent years. The gap between China and the US, in per-GDP R&D spending, has narrowed substantially as a result.
Quantifying these influences on productivity growth is of course difficult, but the direction is clear.
If China can fire all three cylinders of TFP creation, a revival of the productivity cycle is attainable. This can help partially offset diminishing growth contribution from labour and capital, helping China to achieve an economic soft-landing in the coming years/decades.
Sources: AXA IM as at January 2018
Aidan Yao is senior emerging Asia economist at AXA Investment