China’s economic expectations rest on future faultlines with the West as 70th anniversary looms amid trade war

China marks the 70th anniversary of the founding of its People’s Republic on Tuesday, reaching both a notable moment in the story of its ruling Communist Party but, more significantly, what may well be a watershed period in its economic history.

After a remarkable four-decade run of headlong growth that has transformed its economy and society, and stunned the world, China is approaching a crucial turning point.

Already the world’s second largest economy in market exchange rate terms, the largest in purchasing power parity, and the largest manufacturer and trader in goods, China confronts a slew of challenges to its economic ascendancy, including the trade war with the United States, high leverage, mounting demographic pressures, and environmental sustainability problems.

But no challenge faced by China is a critical as whether it can sustain relatively rapid economic expansion and escape the so-called middle-income trap where stalling growth would set a ceiling on its development.

It would be unreasonable to expect the unprecedented and breakneck growth sparked by the reforms of Deng Xiaoping after 1978 to endure. In the 40 years since, the fastest sustained expansion by a major economy in history saw growth average 9.5 per cent, doubling China’s gross domestic product (GDP) every eight years, and lifting 850 million people out of poverty.

In 1981, 90 per cent of the population lived in extreme poverty, but by 2013 the figure had fallen to less than 2 per cent as incomes also soared, up 24-fold from 1978 to 2017, amid mass urbanisation.

Beijing itself already expects slower future growth that it labels the “new normal”. The 13th five-year plan calls for 6.5 per cent annual growth, and there is speculation the 14th plan from 2021 will embrace a still much less ambitious target. The big question is, what can reasonably be expected in the coming two decades?

To sustain rapid growth and avoid the middle-income trap, we find two ingredients are indispensable for aspiring advanced economies: a sizeable, export-oriented manufacturing sector alongside mastery of technology, with strong research and development and innovation driving growth in total factor productivity (TFP).

China enjoys these ingredients in some abundance − all the more essential given that weaker future investment will hit capital accumulation, another key growth ingredient, while a fourth, the working age population, already began to shrink from 2015.

Beijing has made innovation a top priority. While critical observers question whether the desire to preserve the state-led nature of China’s model can be compatible with market-oriented efficiency gains and ongoing innovation, it is hard to argue that this has so far held back the vital productivity growth – at 2.3 per cent in 2018, China’s TFP growth still looks better than that of most other emerging markets.

The government has also pressed forward with productivity enhancing reforms: import tariffs have been cut overall even as those on products from the US have risen, and sectors such as energy, manufacturing, finance and telecommunications have been opened to foreign investment. We expect such reform to persist, gradually.

Yet the swing factor determining China’s technological progress, and so the future path of its productivity and growth, lies only partly in its control. Rising tensions with the US over technological and economic competition is fuelled by concern over China’s rise as such as well as its policies and practises that preclude a level playing field, including initiatives such as the “Made in China 2025” plan to modernise Chinese manufacturing. These tensions could trigger a schism with the West, new barriers to technology transfer and a retreat from the multilateral trading system. This would inevitably curb productivity, putting China on a weaker growth path.

In new forecasts for China’s coming two decades, Oxford Economics anticipate economic and technological interaction with the West to slow but continue, avoiding such a drastic decoupling. Importantly, we do not expect other major developed Western countries to shift fully behind potential US tactics. This matters as the US accounted for only 14.4 per cent of China’s trade in 2018.

So our central view is that China’s trend GDP growth will average at 5.2 per cent in the coming decade to 2028, easing to 4 per cent by 2030, before slowing to 2.8 per cent by 2040. By then, China’s economy would be 51 per cent larger than the US in market exchange rate terms – though this would still leave the population much less rich than those in America, with GDP per head only 39 per cent of US levels.

Our modelling also gauges the consequences of a more severe fracturing between China and the West. On a scenario where significantly greater decoupling between China and the US occurs, but where faultlines with the other advanced economies are more limited, China’s economy ends up 8 per cent smaller and less productive by 2040 versus our baseline forecast.

In a third scenario, where European and Asian developed economies join the US in substantial decoupling, we find a much stronger brake on China and its economy ending some 20 per cent smaller and less productive by 2040.

Beijing may need to strive harder to avoid such breaches, persuading the rest of the world it is serious about supporting globalisation, a multilateral trading system and constructive coexistence. The prize will be fulfilment of its great expectations for China’s economic future. Failure to finesse relations with the West could see those expectations thwarted.

Louis Kuijs is chief Asia economist and Gary Duncan is a director at Oxford Economics, a leading global economic advisory firm