Can we reduce the impact of China’s economic slowdown?

Pundits love debating the Chinese economy’s growth prospects, and nowadays the pessimists are gaining the upper hand. But many are basing their predictions on other economies’ experiences, whereas China has been breaking the mold on economic growth for the last three decades. So, are China’s economic prospects as bad as prevailing wisdom seems to indicate? And, if they are, how can they be improved?

China’s situation is certainly serious. The economy grew by 7.4% last year, the lowest rate since 1990; it is unlikely to meet the official target of 7% this year, and, according to the International Monetary Fund, will probably grow by a mere 6.3% in 2016. Clearly, weak domestic activity and diminished external demand are taking their toll.

China is also losing long-term growth momentum, as falling fertility rates and returns on investment weaken labor-force expansion and capital accumulation. And it is becoming increasingly difficult for China to take advantage of technology-driven productivity gains.

All of these challenges have led former US Treasury Secretary Lawrence Summers and his Harvard colleague Lant Pritchett to argue that China’s growth could slow to 2-4% over the next two decades, as the country succumbs to the historically prevalent growth pattern implied by “regression to the mean.” But, given that China’s growth pattern has, so far, been exceptional, the notion that it will suddenly start following a common trajectory seems unlikely.

Similarly flawed is the view of Justin Lin, former Chief Economist of the World Bank. Lin argues that China can achieve 8% annual growth for another two decades, owing to its enduring “latecomer advantage,” which, among other things, entails rapid productivity gains brought about by technological catch-up with the United States. But this fails to account for the standard growth theory of “conditional convergence”: only economies with comparable structural characteristics, such as labor skills and institutional quality, converge to similar per capita income levels.

For these reasons, I take a more moderate view, predicting that China’s average potential GDP growth will fall to 5-6% by 2030. This expectation is based on a conditional convergence framework that relies on data generated by China’s unique growth experience, as well as those of other economies, over the last three decades.

Unlike Lin, I believe that China’s inevitable economic slowdown is coming soon. But, unlike Summers, I do not believe that it has to be dire. The key to this scenario is that China’s leaders move the economy onto a more balanced and sustainable growth path, based on realistic expectations. They cannot afford to mishandle unavoidable challenges, such as those stemming from domestic institutional weaknesses, political uncertainty, and external shocks.

The first step in any effective strategy must be to recognize that, in such a large and unpredictable economy, the government cannot rely on direct intervention or macroeconomic policies. Instead, it must implement reforms that boost productivity and offset downward pressure on growth.

Reforms in factor markets – labor, land, and finance – are essential. China’s leaders must improve labor-market flexibility and labor mobility; make land use, acquisition, and compensation more efficient; and build a more market-based financial system.

As it stands, China’s financial system is highly regulated and dominated by banks, many of which are state-owned. To change this, the government needs to promote market-based credit allocation. China needs a flexible and efficient financial sector, underpinned by an effectively supervised and regulated capital market, to avoid asset bubbles and support productive and innovative firms.

Similarly, policies to promote continuous technological innovation and industrial upgrading can increase productivity. And measures that increase domestic research capacity – for example, by strengthening protection of intellectual property rights – can nurture innovation.

Reform of China’s massive state-owned-enterprise (SOE) sector would also boost productivity. The recently announced SOE reforms are a promising step. Beyond promoting mixed ownership involving private capital, strengthening corporate governance, and facilitating commercial operations, the reforms promise to open up the energy, resources, and telecom industries to non-state investors. This new round of SOE reform should be pursued diligently.

Such efforts to increase productivity are all the more important as China moves to shift from investment- and export-led growth to a more sustainable model based on domestic consumption and services. Reallocating resources from export-oriented industries to service activities could cause an irreversible drop in productivity. Likewise, while policies that encourage firms to increase wages will raise household income and domestic consumption, wage increases can erode export competitiveness and choke off inflows of foreign direct investment. With rebalancing policies alone unlikely to increase average output growth substantially, enhancing productivity is crucial to China’s long-term prosperity.

The final piece of the puzzle for China is realism. As it stands, the Chinese government is keen to maintain decent growth of about 7% annually while pushing for rebalancing and reform. The risk is that, until reform measures take effect, the authorities may rely on short-term stimulus to meet growth targets, aggravating resource misallocation and structural vulnerabilities. Considering that China’s total debt reached 282% of GDP last year – surpassing America’s debt level – further reckless lending to local governments and private enterprises from the shadow banking sector would hold the economy hostage to the growing risk of a financial crisis.

To avoid such an outcome, China should lower its growth target to about 6% in the coming years. That way, it could pursue the deep reforms that are needed to move the economy onto a more balanced and sustainable long-term growth path.

This article is published in collaboration with [was first published by] Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Lee Jong-Wha is a Professor of Economics and Director of the Asiatic Research Institute at Korea University.

Image: A man walks along an empty street near the central financial district in Hong Kong September 30, 2014. REUTERS/Carlos Barria.