Can China fulfil its untapped economic growth potential?

China's economic slowdown has fuelled widespread speculation about the economy's growth potential. While it is impossible to predict China's growth trajectory, understanding the economy's underlying trends is the best way to derive a meaningful estimate.

Some economists compare China to Japan in the early 1970s. After more than two decades of sustained rapid growth, Japan's economy slackened in 1971, leading to four decades of annual growth rates averaging less than 4 per cent.

This correlation is reinforced by the convergence hypothesis, which states that a rapidly growing developing economy's real growth rate will slow when it reaches a certain share of the per capita capital stock and income of an advanced economy. According to economists Barry Eichengreen, Donghyun Park and Kwanho Shin, that share is about 60 per cent of America's per capita income (at 2005 international prices).

At first glance, the experiences of Asia's most advanced economies - Japan and the four "Asian tigers" (Hong Kong, Singapore, South Korea and Taiwan) - seem to be consistent with this theory.

But Eichengreen, Park and Shin also found that once this income level is reached, annual growth rates tend to fall by no more than two percentage points. Yet GDP in Japan plummeted by more than 50 per cent. Likewise, the Asian Tigers suffered a substantial slowdown.

These inconsistencies can be explained by external shocks. During Japan's boom, its total factor productivity, or the efficiency with which inputs are used, contributed about 40 per cent to GDP growth. When growth plummeted, this productivity fell even faster - a dramatic change clearly linked to the 1971 yen appreciation and the 1973 oil crisis.

External shocks also explain China's slowdown in gross domestic product since 2007. The renminbi's gradual appreciation against the US dollar is the cost shock's main driver, but the demand shock that followed the 2008 global financial crisis aggravated the situation. It is likely that total factor productivity has declined substantially.

Followers of the Austrian economist Joseph Schumpeter view cost shocks as important potential catalysts for structural reform and industrial upgrading.

The problem is that many factors, such as political concerns, can impede this process. If China's government fails to implement the necessary structural reforms, its potential growth rate will never rebound fully.

Given that improving overall productivity is the best way to defend against cost shocks, the new round of structural reform should be aimed at creating conditions for economic transformation and upgrading.

Considering China's per capita income amounts to only about 10-20 per cent of that of the US, its growth potential, as dictated by the convergence hypothesis, is far from tapped. But the degree to which it can fulfil it will depend on its total factor productivity prospects.

In 2007, economists Dwight Perkins and Thomas Rawski estimated that, for China's economy to maintain 9 per cent growth and a 25-35 per cent investment ratio until 2025, it would need to maintain an annual total factor productivity growth rate of 4.3 per cent to 4.8 per cent. This is improbable.

Maintaining 6 per cent annual growth with the same investment ratio would require annual total factor productivity growth of only 2.2-2.7 per cent. With China's productivity still well below that of developed countries, 3 per cent growth in total factor productivity is feasible. Aided by structural reforms, China's economy could expand even faster, achieving 7-8 per cent annual growth over the next 10 years. Either way, convergence will remain swift.

Zhang Jun is professor of economics and director of the China Centre for Economic Studies at Fudan University, Shanghai. Copyright: Project Syndicate