Standard Life Investments

Weekly Economic Briefing

Emerging Markets

Measuring China’s potential


Measuring potential growth in emerging markets is never an easy task, with China being particularly difficult. Potential growth in China is largely assumed to have fallen since the financial crisis as the economy experiences diminishing marginal returns to investment and leverage continues to grow. However, estimating potential growth is complicated by the ongoing structural changes in the economy. Furthermore, scepticism regarding Chinese growth data adds further uncertainty. While it is hard to establish a clear consensus regarding potential growth in China, many economists, both of the bearish and bullish bent generally see it in the 5-6% range. This would fit with past experiences of some developing countries which have been through similar transitions from investment and export-led growth to services-based, consumption-led economies. In particular, China’s growth is certainly in the range that some East Asian economies experienced at similar levels of development (see Chart 9). With China now posting 6.9% year-on-year (y/y) growth for two consecutive quarters (actual growth may have been even higher than official statistics in Q1) the rebound is consistent with the upturn in inflation indicators. Indeed, the GDP deflator increased to 4.5% year-on-year in Q1, and CPI excluding food is at its highest rate since 2011. The rise in inflation suggests that China may be growing above potential and opening a positive output gap. The ongoing supply side reforms and artificial capacity reductions complicates the inflation picture, but it does appear from what little data exists that capacity utilisation has increased after falling for nearly five years (see Chart 10).

Growth comparisons Eating up spare capacity

If China’s current potential growth rate is indeed in the 5-6% range, how long can it grow in this range and what will it look like over the medium term? There are reasons to believe that China’s potential must fall further from here. China’s investment-intensive growth allowed it to outperform many developing economies at similar stages of development. However, this progress makes it more likely to underperform in the future, since it has used up its potential for catch-up growth more rapidly. While using past examples of structurally similar economies can be helpful for estimating what potential growth could be, there are flaws. First, this ignores the massive structural reforms East Asian countries such as Korea and Taiwan undertook at this exact stage of development. Second, it overlooks the impact of debt and demographics. Following periods of rapid investment-led growth, both Korea and Taiwan were able to engineer a rebalancing from investment-led growth towards higher-value added manufacturing and larger shares of consumption. The shift involved significant structural reforms and reduction in state intervention in domestic markets. These reforms allow increases in productivity to offset declining investment, and growth stayed in a stable range for many years. China’s current situation is more complicated than that of Korea or Taiwan when they embarked on structural reforms. China has similar structural inefficiencies such as a heavy share of SOE influence in the economy, but it has the added complication of a large overhang of debt. Looking at the factors of growth – labour, capital and productivity – China’s labour force is set to slow significantly; because of past overinvestment China’s investment intensity must slow; therefore future growth will rely heavily on productivity gains. In this respect reforms are crucial.

Alex Wolf, Senior EM Economist