How fast will China grow?

In the 35 years since China’s transition to a market economy began, the country has grown at an average rate of 9.8% – an explosive and unprecedented rise. But there are signs that the Chinese miracle is coming to an end – or at least that the country’s economic growth is slowing. China’s growth rate has been falling since the first quarter of 2010. In 2014, it was a relatively anemic 7.4%.

China’s economic growth is likely to continue to face stiff headwinds this year as well, at least when compared to previous decades. As policymakers draw up the country’s 13th five-year plan, they will grapple with a fundamental question: How fast can China expect to grow?

In setting a country’s GDP target, the first thing to understand is the economy’s potential growth rate: the maximum pace of expansion that can be attained, assuming favorable conditions, internally and externally, without endangering the stability and sustainability of future growth. As Adam Smith discussed in An Inquiry into the Nature and Causes of the Wealth of Nations, economic growth depends on improvements in labor productivity, which today result from either technological innovation or industrial upgrading (the reallocation of productive capacity into new sectors with higher added value).

But developed countries at the innovation frontier are at a disadvantage. To benefit from new technology, they must create it. Developing countries, by contrast, possess a “latecomer advantage,” because they can achieve technological advances through imitation, importation, integration, and licensing. As a result, their costs and risks are lower. Over the last 150 years, developed economies have grown at an average rate of 3% per year, whereas some developing countries have achieved annual growth rates of 7% or higher for periods of 20 years or longer.

To calculate how much of a latecomer advantage China has after 35 years of unprecedented growth, one needs to look at the gap between its levels of technological and industrial development and those of high-income countries. The best way to see this is by comparing its per capita income, adjusted for purchasing power parity (PPP), with those of developed countries. The larger the gap in per capita income, the larger the latecomer advantage and the greater the potential for growth.

In 2008, China’s per capita income was just over one-fifth that of the United States. This gap is roughly equal to the gap between the US and Japan in 1951, after which Japan grew at an average annual rate of 9.2% for the next 20 years, or between the US and South Korea in 1977, after which South Korea grew at 7.6% per year for two decades. Singapore in 1967 and Taiwan in 1975 had similar gaps – followed by similar growth rates. By extension, in the 20 years after 2008, China should have a potential growth rate of roughly 8%.

But potential growth is just one part of the story. Whether it can be achieved depends on domestic conditions and the international environment. In order to exploit its latecomer advantage, China must deepen its reforms and eliminate its economy’s residual distortions. Meanwhile, the government should play a proactive role in overcoming the market failures – such as externalities and coordination problems – that are certain to accompany technological innovation and industrial upgrading.

China has the potential to maintain robust growth by relying on domestic demand – and not only household consumption. The country suffers no lack of investment opportunities, with significant scope for industrial upgrading and plenty of potential for improvement in urban infrastructure, public housing, and environmental management.

Moreover, China’s investment resources are abundant. Combined central- and local-government debt amounts to less than 50% of GDP – low by international standards. Meanwhile, private savings in China amount to nearly 50% of GDP, and the country’s foreign-exchange reserves have reached $4 trillion. Even under comparatively unfavorable external conditions, China can rely on investment to create jobs in the short term; as the number of jobs grows, so will consumption.

The external scenario, however, is gloomier. Though developed countries’ authorities intervened strongly in the aftermath of the global financial crisis in 2008, launching significant fiscal- and monetary-stimulus measures, many of their structural shortcomings remain unresolved. “Abenomics” in Japan has yet to yield results, and the European Central Bank is following in the footsteps of America and Japan, pursuing quantitative easing in an effort to shore up demand.
Employment in the US is growing, but the rate of workforce participation remains subdued and the economy has yet to attain the 6-7% growth rates usually recorded in a post-recession rebound. The US, Europe, and Japan are likely to experience continued sluggish performance, inhibiting China’s export growth.

As a result, Chinese growth is likely to fall below its potential of 8% a year. As policymakers plan for the next five years, they should set China’s growth targets at 7-7.5%, adjusting them within that range as changes in the international climate dictate. Such a growth target can help to stabilize employment, lower financial risk, and achieve the country’s goal of doubling income by 2020.

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

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Author: Justin Yifu Lin, a former chief economist and senior vice president at the World Bank, is Professor and Honorary Dean of the National School of Development, Peking University, and the founding director of the China Center for Economic Research.

Image: Pedestrians walk under red lanterns in Shanghai, January 24, 2014. REUTERS.