Source: Financial Times

The former US Treasury secretary Lawrence Summers and his Harvard colleague Lant Pritchett recently delivered a reality check on the Chinese economy’s prospects by publishing a study indicating that China’s growth will average only 4 per cent a year for the next two decades. At the same time, the Conference Board issued its study with similar conclusions.

The Summers-Pritchett study is a statistical exercise drawing on cross-country experiences, which is then applied to China (and India). The Conference Board projection is China-specific but makes some debatable assumptions about the lack of reform. It also discounts quality and productivity increases while coming up with its slow growth scenario. In contrast, staid institutions such as the World Bank and International Monetary Fund foresee annual growth rates closer to 7 per cent for 2020 going down to 6 per cent by 2025, and one must not overlook the pessimists who see an imminent financial crisis with growth collapsing.

No other country generates such disparate views, making it difficult for more dispassionate China watchers to decide whom to believe. Probing deeper into China’s growth, it seems the answer may depend on the less recognised issue of whether Beijing succeeds in restructuring its fiscal system.

The Summers-Pritchett analysis concludes that economies that grow at high rates for extended periods typically follow the principle of “regressing to the mean”, with growth subsequently falling significantly. Using this principle they argue that China’s growth will average 5 per cent a year up to 2023 and 3 per cent up to 2033. They note that countries cannot expect rapid growth to last for more than say a decade before succumbing to this principle. China was already the exception as it had been growing at about 10 per cent a year for the past three decades.

That a 10 per cent rate of annual growth cannot continue forever is clear. The current slowdown to about 7 per cent represents the inevitable shift to a slower growth trajectory as China’s economy matures. Is China’s destiny to go straight from 10 per cent a year to say 5 per cent by 2020 or is there an intermediate phase with sustainable growth of about 7 per cent for another five to 10 years? The experiences of Japan, South Korea and Taiwan suggests there may be a transitional phase when growth slows down by 2-3 percentage points from its highs, followed by a third phase once China’s economy has reached high-income levels and the growth rate falls by another 2-3 points.

China’s challenge is not that it lacks the productive capacity to grow at 7 per cent a year, but that this rate is not currently sustainable because of inadequate demand. Hence, Beijing has resorted to selective stimulus policies which impact negatively on its need to deleverage. On the supply side, China’s strong infrastructure base combined with rapid expansion of its higher education system means that it has both the physical and human capital resources to grow rapidly. Moreover, there are still considerable productivity gains to be secured from urbanisation and a flourishing private sector, making a medium-term 7 per cent growth target realistic.

The problem is the inadequacy of demand. China’s rapid growth before the global financial crisis was partly due to strong external demand from the US and Europe which has now waned. China’s investment rates will decline in response to lower returns and the need to deleverage. Thus, most China watchers have argued that the solution lies in increased personal consumption.

However, personal consumption has been growing at about 8-9 per cent annually in real terms and is unlikely to rise if gross domestic product growth moderates – even with an expected structural shift in its composition toward services. Where can China find the demand to make up for slower growth in investment and weaker export markets?

The answer lies in a restructuring of the Chinese fiscal system. China’s budget is unusual in its limited size and in the way assignments of revenue and expenditure are misaligned between Beijing and the provinces. For a socialist economy that owns or controls all the key resources and dominates all major strategic activities, the overall budget is surprisingly small at about 28 per cent of GDP. This compares with 40-45 per cent for the major OECD economies and about 35 per cent for upper middle-income countries. Consequently, as noted in the World Bank’s China 2030 report, the Chinese budget provides a third less social services and other consumption needs as a share of GDP than other comparable countries. This is a major factor explaining why the share of total consumption (household and government) is about 10-15 per cent lower than in other comparable countries.

At the end of June, Beijing signalled its most important reform yet, promising the completion of the detailed framework for a major fiscal overhaul within two years. Compared with the attention China watchers pay to minute shifts in financial indicators such as interest and exchange rates, these fiscal reforms have received relatively little attention.

If implemented, the reforms have the potential to increase government expenditures by 4-5 per cent of GDP. This would ensure that there is adequate demand for China to still grow at a sustainable rate of 7 per cent a year to the end of this decade. By 2025, the regression to the mean that Profs Summers and Pritchett predict will have begun but it need not be any sooner.

This article was originally published by the Financial Times.