China's Slowdown

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by: Jeffrey Frankel

Investors worldwide are closely watching the steep decline in China's stock market. The Shanghai Stock Exchange Composite Index is down more than 40% since June 2015.

The reason observers are concerned is not because they themselves are invested: China's stocks are overwhelmingly held by Chinese themselves. Rather, many are interpreting it as evidence that China's economy is going down the tubes.

China's growth rate has indeed slowed down and there are plenty of reasons to believe that the slowdown is not just temporary. But none of them has much to do with the stock market.

For one thing, market prices are still well above where they were in 2014. That was a time when many observers were bullish on China, proclaiming that its economy had just surpassed the US to become the world's largest, on the basis of new PPP-based GDP statistics. But in fact the slowdown in Chinese growth began four years ago. According to the official statistics, growth averaged 10% over the three decades 1980-2010, but slowed down to the 7%-8% range in 2012-14.

Indeed, the reason that China's stock market started to ascend at the end of 2014 is that the People's Bank of China began to cut interest rates in November, in an appropriate response to the slowdown in economic growth that was already evident. But the market's continuing rise took on the character of a credit-fueled bubble in the spring of 2015. The peak came on June 12, when the China Securities Regulatory Commission tightened margin requirements.

The bubble has now been reversed. That doesn't necessarily convey much information about China's growth prospects.

There are plenty of reasons not to be surprised that China's growth rate has slowed down and not to expect it to return to 10%. The human instinct of some forecasters five years ago was simply to extrapolate the preceding three decades. But casting a wider statistical net would have revealed that a fourth decade at 10% would have been historically unprecedented.

The Middle Kingdom is not exempt from the broader statistical regularities. Some see the slowdown as a case of the middle-incometrap. Others find that the more relevant statistical pattern is regression to the mean in growth rates.

What are the economic forces behind the tendency for a rapidly growing country to slow down? There is a wide variety of possible economic interpretations. Six come to mind:

  • One is diminishing return to capital. China's investment in steel mills, transportation infrastructure and residential construction became "too much of a good thing."
  • Another interpretation is the observation that productivity growth is easier when it is a matter of copying the technologies, production processes, and management practices of the Western countries. When the gap between the economic frontier and the newcomers narrows, the latter countries have to do some of the innovating on their own.
  • A third explanation is that rural-urban migration has been a big source of China's growth, but that the surplus labor has finally been used up, wages have risen, and the competitive advantage in labor-intensive manufactures has been lost. (The "Lewis turning point" has been reached.)
  • A fourth is that the population is aging. The working-age population peaked in 2012. The ratio of retirement-age people to working-age population is rising. This demographic transition occurs naturally in advanced countries; but the one-child policy accelerated it prematurely in China.
  • A fifth is that urban land prices have been bid up and the "carrying capacity" of the environment has been exhausted.
  • A sixth is that the composition of the economy is shifting away from manufacturing and into services, which is appropriate but which entails slower growth because in all countries there is less scope for productivity growth in services than there is in manufacturing.

Thus a shift from 10 per cent growth in China to a more sustainable long-term 5-7 per cent trend is perfectly natural. The important question is whether the transition takes the form of a soft landing or a hard landing. In a soft landing China would continue to grow at the slower-but-sustainable trend rate. In a hard landing it would suffer a financial crisis and more severe economic recession.

High dependence on investment spending and debt financing can work well during a high-growth phase but then lead to excess capacity and financial crisis when the long-run growth rates slows down. Precedents include post-1980s Japan and 1997-98 Korea.

Some say that the official statistics seriously overstate GDP and that the true growth rate has already fallen well below the 6.9 per cent that the government has reported for 2015. It is indeed suspicious that official growth statistics seem in most years to come close to the numbers in plans that had been announced by the government ahead of time. So the skeptics reasonably turn to more tangible measures. They point out that energy consumption, freight railway traffic, and output of such industrial products as coal, steel, and cement have slowed sharply. (These are components of the so-called Keqiang Index.) But Nicholas Lardy persuasively argues that those statistics are also consistent with the interpretation that the composition of China's economy has been shifting away from heavy manufacturing and toward services.

The shift away from manufacturing to services is one component of a desirable package of policies to smooth the transition to a sustainable growth rate. Another is a reduced reliance on investment spending and export demand, and a greater role for household consumption. Other desirable reforms include increasing the flexibility of land markets and labor markets. For example labor mobility is still impeded by insecure land rights in the countryside and the hukou system in the cities. More generally, the markets should continue to play a growing role in the economy. State-owned enterprises should be reined in. Reforms are also needed in health care, social security, and the tax system. And, of course, environmental regulation and the end of the one-child policy.

Chinese economists and leaders know all this. Indeed a very similar list of reforms was the outcome of the Communist Party's Third Plenum in 2013. Beijing has taken some steps to implement them over the last two years. But there is still a long way to go and it is by no means guaranteed that the implementation will be fully successful. As Shang-Jin Wei of the Asian Development Bank points out, the fate of China's economy depends a lot more on how well the reforms go than on anything about last year's stock market bubble and its subsequent reversal.

This is an extended version of a column that appeared at Project Syndicate. Comments can be posted there, or at the EconBrowser version