Economic Research:

Slower Growth In China: Inevitable, Necessary, And Now More Palatable

Credit Market Services: Paul F Gruenwald, Asia-Pacific Chief Economist, Singapore (65) 6216 1084; paul.gruenwald@standardandpoors.com

Table Of Contents
Inevitable: Economic Convergence Means Slower Growth Necessary: The Trade-Off Between Fast Growth And Financial Stability Has Sharpened Palatable: A Stronger Labor Market Bolsters Social Stability It's Not Just About the Pace of Growth, The Composition Matters As Well Endnotes

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Economic Research:

Slower Growth In China: Inevitable, Necessary, And Now More Palatable

The unexpected slowdown in China's growth has been a major development for the global economy of late. Perhaps more importantly, expectations for China's growth have fallen as well. The consensus forecast has dropped a full percentage point over the past year to 7.5% and continues to decline (1). Standard & Poor's Ratings Services estimates that real GDP could grow just 7%-7.5% for 2013 and beyond. That contrasts with growth of well over 9% on average during 2000-2011, which includes the impact of a successful policy response to the outbreak of the global financial crisis (2). Our lower forecast is mostly attributable to our reassessment over how the Chinese leadership will react to the slowdown in growth. The new administration, led by President Xi Jinping and Premier Li Keqiang, seems comfortable with the current pace of activity. Indeed, contrary to initial market expectations, the central government has made no announcements of a significant stimulus plan. Aside from some minor, targeted policy adjustments, the authorities have let growth slow. The previous leadership team of Hu Jintao and Wen Jiabao, in contrast, were willing to aggressively loosen policy settings to support high growth--including in response to the global financial crisis. Overview The days of GDP growth of over 9% in China appear over. Growth of 7%-7.5% seems to be the "new normal"; the authorities now seem comfortable with growth rates that they recently viewed as unacceptably low. We see three elements at work in the restrained policy reaction: first, growth was bound to slow inevitably as China converges with the advanced economies; second, more leverage in the economy means that the growth versus a trade-off in financial stability is more fully in play; and third, a tighter labor market with higher wage growth means that slower GDP growth is now more politically palatable. While slower growth will make the Chinese economy more sustainable on some metrics, there is still a need to rotate the drivers of growth toward consumption, which has yet to happen.

How should one think about a slower, but still quite respectable, pace of Chinese growth? What are the drivers and the trade-offs? What are the considerations that likely inform the authorities' revised approach to policy reactions? Does slower growth put the economy on a sounder longer-term footing? In our view, the government's reduced comfort level for growth reflects its assessment that a slowdown in GDP growth is inevitable, necessary, and now more palatable.

Inevitable: Economic Convergence Means Slower Growth

China's growth is on a path of secular decline, mostly because of the equivalent of economic gravity, commonly referred to as convergence. Put simply, an economy can grow fast in the catch-up phase of its development, mainly

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

because of strong productivity gains as it does not have to "reinvent the wheel." But as the economy closes the gap with the advanced economies, this ability to grow fast diminishes as productivity gains converge (slow) to those of the economies on the frontier. We can analyze GDP growth by using a simple accounting identity. Changes in GDP can be roughly broken down as follows:

This identity says that growth can come from three sources: first, adding more labor; second, adding more capital (equipment and machinery); and third, combining these two factors of production (labor and capital) in more efficient ways. The last of these is known as total factor productivity (TFP). Most of China's growth has come from capital accumulation (it's an investment-led economy after all) and TFP growth, with only a modest contribution from labor (see table 1) (3). A converge assumption implies that China's TFP growth looks likely to fall as it continues to approach the global frontier. Investment-led growth has likely reached its limits and the growth of the labor force will continue to decline.
Table 1

Contribution To GDP Growth 1996-2011

Mature Economies GDP Growth Labor Capital TFP 2.1 0.5 1.2 0.4 China 8.7 0.6 5.8 2.4

Sources: Conference Board, Standard & Poor's Ratings Services.

This phenomenon of slowing growth is certainly not unique to China; we have seen it repeatedly in Asia (see chart 1). The industrialization of the region began with Japan's miracle growth period that spanned the 1950s through the 1970s. This was followed by the "tiger economies" of Korea and Taiwan, and then Hong Kong and Singapore in 1970s and 1980s. China's fast growth period began in the late 1980s following the reforms that Deng Xiaoping launched in the late 1970s.

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

Chart 1

All told, economic forces dictate that China's growth rate should continue to decline on a trend basis. That is, a slowdown in secular growth is inevitable. This will not necessarily be true on a year-on-year basis owing to business cycles as well as other short- and medium-term factors. But it does suggest that trying to artificially maintain previously high growth rates through aggressive stimulus measures will become an increasingly futile, expensive, and ultimately wasteful proposition.

Necessary: The Trade-Off Between Fast Growth And Financial Stability Has Sharpened
China's growth model is centered on state-led investment, financed with state-led bank credit, implementing the state's five-year plan. Indeed, the investments of China's massive state-owned enterprises have been a key driver of Chinese GDP. Investment has contributed roughly two-thirds to growth over the past decade or so. And China's share of investment-to-GDP, at around 50%, is one of the highest in the world. (This implies that consumption has an unusually small share of GDP.) The banks have been the main financing vehicle for investment, with the "big five" state banks traditionally dominating the financial sector.

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

This built-for-speed model proved effective in combatting the effects of the global financial crisis. Following the onset of the crisis in late 2008, then-Premier Wen Jiabao announced an aggressive plan comprising a major fiscal stimulus concentrated on infrastructure spending and an extraordinary expansion of bank credit. In a more recent twist, the rise in investment demand from the stimulus plan led to a surge in credit sourced from outside of the formal banking sector. Much of the financing has been concentrated in trust accounts and other off-balance sheet financing vehicles, including at local governments. The policy response of the previous government not only revived Chinese growth but generated positive growth spillovers regionally and globally. The International Monetary Fund characterized China's policy response as "quick, determined, and effective" (4). However, China now has the equivalent of a "stimulus hangover." This is shown in the stock of public debt as well as the stock of financial sector credit (we broadly define public stock to include financing of local government infrastructure activities). Data from the IMF show that as of 2012 the stock of fiscal debt stood at 46% of GDP, up from 37% in 2008, with a fiscal deficit of about 10% of GDP (these figures are on an augmented basis). More importantly, the stock of social financing rose to 195% of GDP in the first quarter of 2013 from 129% in the fourth quarter of 2008, with most of the increase coming outside of the banks. (Social financing is a broad-based measure of financial sector credit intended to capital off-balance sheet as well as local government debt.) These indicators suggest that China's space to respond to future crises through policy adjustments has decreased. Additional stimulus programs aimed at pumping up growth would almost certainly lead asset quality to deteriorate in the financial sector. Put alternatively, the trade-off between higher growth and stability in the financial sector has worsened during the post-crisis period.

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

Chart 2

A related issue in terms of the growth accounting framework is the falling productivity of investment. A central idea in economic theory states that as the amount of investment increases, all else constant, the incremental contribution to output will decline. Economists call this the Law of Diminishing Marginal Returns. The implication is that as the amount of investment in the economy exceeds its optimal level, the returns will be too low relative to cost, and therefore the loans financing that investment will become impaired. Therefore, relying too much on investment in general and on stimulus plans to prop up growth--in the particular case of China--is likely to undermine financial stability.

Palatable: A Stronger Labor Market Bolsters Social Stability

An arguably overlooked reason why the Chinese authorities now appear to tolerate slower growth is the strength of the labor market. Wages have been rising at double-digit rates in recent years, and there's less need to generate fast growth in employment stemming from fast growth in GDP in order to maintain social stability. A wide range of analysts over many years argued that the central government's need to maintain social stability was behind the brisk pace of economic activity, which took the form of fast employment generation in the rising and

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

better-paying manufacturing sector. The underlying dynamic was the ongoing transformation from a largely agricultural, low productivity economy into a modern, urban, industrialized, and higher productivity one. As this transformation proceeded, workers were "released" from the agricultural sector, increasing labor supply in the manufacturing sector and putting pressure on manufacturing wage growth. To preserve social stability, it was often argued, the government needed to maintain fast growth and thereby increase manufacturing labor demand, putting a floor on wages. The minimum GDP growth rate often cited as necessary to achieve this social objective was about 8%. In recent years, however, this dynamic has changed. Manufacturing wages in China have been rising at double-digit rates. More importantly, the labor market looks tighter, with demand now outstripping supply (see chart 3). Some observers characterize this change as China having reached its "Lewis turning point," named after the work of the English development economist Arthur Lewis, who formulated his ideas in the 1950s (5). Put simply, the "excess labor pool" stemming from the shift in the structure of the economy towards manufacturing is much less of a factor in the calculus of political stability than before.
Chart 3

Is this new state of play in the labor market likely to endure? And, by extension, will the Chinese authorities be under less pressure in the future to maintain high GDP to support wages and social stability? In our view, the answer is yes. The reason is demographic. Owing in large part to China's "One Child Policy," population growth has slowed and the

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

working age population aged 20-39 has already peaked. The IMF recently suggested that the excess supply of labor has peaked as well and "is on the verge of a sharp decline." (6)

It's Not Just About the Pace of Growth, The Composition Matters As Well
Will slower growth alone be sufficient to put the Chinese economy on a sustainable growth path? The answer is a partial yes, in the sense of safeguarding financial sector stability and leaving some policy space to act should the downside risks materialize. But the composition of growth remains skewed toward investment. We see a "sweet spot" in the trade-off between financial stability and growth. If growth is too fast, then the return on investment and therefore the quality of credit used to finance that investment will suffer. If growth is too slow, the problem of bad-debt creation is solved, but the ability to service the existing debt is impaired. The new leadership seems to understand both sides of this trade-off and has verbally drawn a line in the sand at 7% growth as a downside limit. The rotation of growth toward consumption is a related and perhaps more challenging issue. China has the lowest consumption-to-GDP ratio in Asia (7). Structural reforms in the areas of social insurance, state-owned enterprises, the financial sector, and the exchange rate regime would channel more income and purchasing power into the household sector. Some progress is being made, but these structural challenges will take many years to complete and bear fruit.

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Economic Research: Slower Growth In China: Inevitable, Necessary, And Now More Palatable

Chart 4

Finally, we should keep the slowdown in Chinese growth in perspective. Given China's status as the world's second-largest economy, this slowdown has clear global implications. But the glass remains more than half full. Using China's 15% weight in 2012 world GDP (purchasing power parity basis) (8), a 2 percentage point slowdown in Chinese growth knocks off 0.3 percentage points from global GDP growth. But China's contribution to global GDP growth is still more than 1 percentage point (above that of the U.S.), suggesting that China continues to punch well above its weight in generating global GDP.

Endnotes
(1) Asia-Pacific Consensus Forecasts, August 2013 (2) Asia-Pacific's Growth Continues to Slow Along With China, But Japan Looks Ready to Blossom, Aug. 5, 2013 (3) Source: The Conference Board Total Economy Database, Summary Statistics 1996-2013 at http://hcexchange.conference-board.org/retrievefile.cfm?filename=SummaryTable_hc_Jan152013v21.pdf&type=subsite (4) See http://www.imf.org/external/pubs/ft/scr/2010/cr10238.pdf

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(5) See Lewis, Arthur (1954), "Economic Development with Unlimited Supplies of Labor," Manchester School of Economic and Social Studies, Vol. 22, pp. 13991. (6) See http://www.imf.org/external/pubs/ft/wp/2013/wp1326.pdf (7) Asia's Unfinished Homework: Rebalancing Growth To Make It Sustainable, May 16, 2013. (8) See http://databank.worldbank.org/data/download/GDP_PPP.pdf.

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