Is China’s productivity miracle over?

By Leith van Onselen

Below is a facinating presentation by UBS’ George Magnus, which examines whether the Asian Miracle is coming to an end.

Magnus’ sections on China are particularly pertinent for Australia. First, Magnus discusses China’s falling rates of productivity:

In China, the higher contribution of TFP to economic growth in the 2000s shows up clearly in Chart 4. Roughly half of China’s TFP growth has come from the transfer of labour from the rural sector to higher value-added, urban-based, jobs, mostly in industrial manufacturing for export.

But in Chart 5, the sequential changes in growth contributions stand out more clearly. The labour contribution is just about drying up, while the investment and TFP contributions are clearly sliding.

The slowdown in TFP growth, along with investment, testifies to the need for reforms to raise the growth and levels of efficiency, and as explained later, to change the contributions and functions of the State vis-a-vis the private sector – probably one of China’s biggest structural challenges in the next decade.

For China and Asia generally, higher sustainable economic growth, based around greater efficiency and innovation, depends on political and institutional reforms. Without these, we believe the miracle could fade and slower long-term growth will result – not a cheery prospect, given high expectations.

Magnus also notes the following about the need for reform in China:

Earlier, we alluded to China’s rapid ageing and labour force consequences, the excessive weight of investment in GDP, and the slowdown in TFP and potential growth. The principal task of rebalancing the economy, as is well understood, is to raise the consumption and personal income shares of GDP, while managing the decline of the investment sector’s weight in and contribution to growth.

As and if this happens, China’s infamous external surplus, which is the difference between savings and investment, and currency reserve accruals should decline permanently. But we see little persuasive evidence that this rebalancing is happening yet. True, China’s current account surplus has fallen from 10% of GDP before the crisis to 2.8% of GDP in 2011, i.e. the imbalance between savings and investment has declined already. Investment has risen for structural reasons, due to strong manufacturing productivity, the relocation of global manufacturing to China and its low domestic cost base. Cyclically though, the main factors were the surge in investment after 2008, weaker foreign demand for exports more recently, and some decline in the terms of trade (higher import prices and real exchange rate).

Shouldn’t we expect this sort of rebalancing to continue? As China’s urbanisation rate rises, aggregate consumption should increase. Rapid ageing and labour market effects should push real wages up and lower aggregate savings. And slowly, government policies designed to bolster income security and transfer income to people with a high marginal consumption propensity, should also help to lower savings. In the last 3 years alone, access to primary healthcare has improved, especially in rural areas, the government has acted to achieve universal health insurance by the end of this year, government pension schemes have been expanded and made more flexible for job changers, and a major social housing programme is underway.

At the same time, the growth of fixed asset investment has been slowing down to a near 5 year low (20.4% in the year to June). It portends weaker growth in real capital investment growth to levels that are more in line with or a bit higher than real GDP growth. Last year, the increase was around 9%, down from 19% recorded in the wake of the 2008 stimulus programme. The monthly fixed asset numbers will soon tell us if the government’s latest moves to ease monetary and credit restraints and spur new infrastructure investment are succeeding in stabilising the investment rate, or failing regardless.

Unfortunately, there aren’t strong reasons to expect current savings and investment trends to linger, and absent a major change in economic direction, China’s surplus is likely to start expanding again before long…

There is certainly no evidence that aggregate household savings are declining as a share of GDP, or that the aggregate consumption share has started to rise from a deep trough – regardless of the buoyancy of retail sales…

The slowdown in investment growth, as such, is welcome. But the danger is that easier financial policies and higher infrastructure spending approvals will simply prop up a model that is sustaining uneconomic levels of production and investment…

Magnus then concludes the following about China:

One way or another, China is going to rebalance. The question is whether it occurs in an orderly fashion with the investment side of the economy slowing to a rate less than the growth in GDP, but still growing. Or whether it happens in the context of a sharp decline in investment, with more alarming economic and political consequences that will cut across the economy.

After two decades of unparalleled economic success, we believe China now needs a reform programme on a scale similar to that adopted 30 years ago. Without it, a heavily investment-centric and credit-intensive economic model could soon become unstable, and later stall in a middle income trap. There’s only so much labour transfer from rural areas to urban factories. There’s a limit to how high the investment share of GDP can go. Rapid population ageing is chipping away at Chinese growth. The exceptional impact of accession to the WTO a decade ago is fading. And the significant, direct role of the government, state banks and SOEs in the economy as agents of economic policy, and owners and providers of heavy investment and infrastructure may no longer be appropriate as the economy becomes richer, more complex, and in need of greater competition and innovation.

In our view, the bottom line about reform is whether the CPC is willing and able to do three fundamental things. First, we feel it should move towards a fuller market economy, changing the legacy role of the state. Second, it should allow power to drain from itself, regional governments, state entities and the military towards the private sector and households. And third, it should introduce rules and transparency, including adoption of the rule of law, into the overall system of governance.

You can be optimistic or pessimistic about the outcomes, but you can’t speak of the China or, by implication Asia, miracle nowadays, without considering the chances of successful political and institutional reforms. More to the point, perhaps, what would the consequences be for China if, for existential reasons, the CPC wasn’t willing or able to go down this path?

Asia is the Miracle Over – George Magnus UBS