How fast is China actually growing?

In the closing speech at the National People’s Congress on March the 16^th, Premier Li Keqiang once again stressed that China strives to transform investment-driven industrial economy into one driven by consumption and services. He also said that high real economic growth was a precondition, stating a target of 6.5% to 7% annual growth for the next five years. These statements come at a time when it appears that China’s economy is gradually relinquishing its role as the catalyst for global growth. This Special presents our own estimate of Chinese growth and considers China’s growth potential based on the underlying determinants.

Many economists agree that the actual rate of growth in China in 2015, and possibly in previous years as well, has been significantly below the official growth rate reported by the Chinese government. Data published by the Conference Board shows that annual real GDP growth per capita has softened since 2010 from 7.2% to 3.9% (Figure 1).

In particular, there are doubts if nominal gross domestic product (GDP) is deflated using the correct GDP deflator. Authorities seem to do their best to compile accurate nominal GDP figures, but tweak the deflator in order to smoothen the real growth rate towards the official growth target. Using producer prices as a basis for deflation instead of value added prices leads to an underestimation of price levels and, consequently, an overestimation of real GDP growth.[1]

[1] Normally, nominal GDP data is adjusted for price effects (using a value added deflator) to obtain real GDP. In China however, it appears that the adjustment in 2015 is not based on the price development of value added, but rather on producer prices, which also includes import prices. Given the collapse in commodity prices in 2015, producer prices were much more subdued than value added prices.

In 2007, premier Li Keqiang, then the party chief in Liaoning, told the US ambassador that regional GDP figures were “man made” and unreliable. He said that he rather looked at electricity usage, the volume of rail freight and bank loans to keep track of economic activity in his region. Based on these three indicators, The Economist compiled a ‘Keqiang index’ to monitor Chinese economy and, since then, many economists have developed composite indicators to gauge Chinese growth.

The China Activity Indicator (CAI)

We have also developed such a composite indicator: the China Activity Indicator (CAI). This is inspired by the work of the British consultancy agency Capital Economics.[2] Our CAI is based on six ‘traditional’ indicators that are available on a monthly basis:

1. The volume of freight transported by road, by air, by rail and by water;

2. The number of passenger kilometres by road, by air, by rail and by water;

3. Volume of freight handled at major coastal ports;

4. Electricity output;

5. Floor space of real estate under construction;

6. The number of companies;

Since China is attempting to effect a transition to a more consumption-driven economy, we have added a consumption indicator to the CAI:

7. The number of overnight stays by Chinese tourists in Switzerland.

This indicator shows growing purchasing power by the Chinese middle class, an area in which there is still much potential for growth. Only 4% of the Chinese population currently holds a passport, but according to Goldman Sachs (2015) this will increase to 12% over the next decade.

Figure 2 shows that the CAI follows the official growth figures fairly closely until mid-2014. After an initial shock that started in July 2014 and a brief recovery, it shows a large collapse in growth early 2015. Economic growth dropped from 6.8% in December 2014 to 4.8% in January 2015. If we include our consumption indicator in the CAI (the light blue line in Figure 2), the picture is slightly more optimistic. Growth was still much lower at the beginning of February, but stabilises at a higher level of around 5¼%.

[2] We wish to thank Julian Evans-Pritchard for his assistance in reproducing the China Activity Proxy of Capital Economics.

In our opinion, there are several reasons behind the slowdown of the Chinese economy. Growth in manufacturing and construction last year was much lower than in previous years. This was partly the result of a tightening of monetary conditions by the central government at the end of 2014 (see Figure 3). The effect became visible early 2015, just at the time that the government prohibited opaque special financing vehicles that has been used by local governments to finance construction projects. This prohibition made it increasingly difficult for local governments to raise finance and investment growth slowed as a result because a significant portion of investments originate from local governments. The slowdown also prompted Chinese households and firms to transfer assets to stock markets, which led to a huge rally in equity prices. Measures taken by the Chinese government to stimulate lending and thereby restore investment growth did not succeed initially, partly as a result of the volatility in the stock markets that had now been created and fluctuations of the yuan exchange rate. It was only after radical measures were implemented, such as a significant reduction in interest rates and reserve requirements for banks, that credit growth began to recover towards the end of last year and early 2016. This should also stimulate investment growth, although this is not yet visible in the figures.

After a sharp stock market correction mid-2015 and in September, there was a surge of businesses and investors choosing more clandestine routes to move their assets overseas. Net capital outflow data from February indicates, however, that capital flight might be subsiding. This would appear to support our previous findings that a significant portion of the observed capital outflow repayment of foreign debt by Chinese firms and banks.

The important question is: how fast can China grow in the coming years? Are the official growth targets realistic if we look at the underlying factors that determine growth? First we consider employment growth, and secondly labour productivity growth.

Employment growth

The development of the working-age population in China is currently at its peak. This means that little potential remains for strong employment growth, and that even in the short term this factor may exert a braking effect on growth (Figure 5).

Productivity

A second pillar of the economic growth is labour productivity growth. Many countries that go through the transition from an emerging market to an industrialised economy fall into what is often referred to as the ‘middle income trap’. This means that growth falls significantly after a certain threshold is reached, as wages start to rise and the emerging economy loses its comparative cost advantage. Japan and South Korea are among the exceptions that have managed to avoid this middle income trap (see FRBSF). These countries have succeeded in making a transition by boosting labour productivity growth by investing in high-value technological sectors. Figure 6 shows that China still has a long way to go before it even comes close to the productivity levels seen in Japan and South Korea.. With labour productivity of USD 7 per hour, China has in fact one of the lowest levels of labour productivity of all the countries for which the Conference Board has data available. China’s productivity level is equal to that of Pakistan, and well behind a country like Armenia. By comparison, the US and Germany are at USD 66 and USD 64 per hour, respectively.

This low level of labour productivity implies that China has huge catching-up potential. Various studies indeed show that countries that invest in their own technological absorptive capacity can benefit from productivity gain due to catching up with countries that are technologically more advanced (see for instance Griffith et al., 2004). At the NPC it was clear that the Chinese government also wants to reduce overcapacity in traditional sectors (such as steel, manufacturing and construction) and make the transition to a consumption and services-driven economy in combination with high value technological sectors.[3]

There are some early indications that China is actually making this transition, with numerous initiatives being launched to promote innovation and entrepreneurship. Chinese consumers are also prepared to spend, with e-commerce emerging as a dominant factor in their purchasing pattern (see Figure 7). In addition, consumer preferences are changing (see KPMG, 2015): 2015 witnessed a strong increase in mobile phone sales, electronics, health care, entertainment and tourism.

[3] The Minister of Human Resources and Social Security announced on 29 February that 1.3 million jobs will be cut the coal industry and half a million in the steel sector. The Chinese government has made a reservation of 100 million yuan in order to relocate laid-off personnel and prevent social unrest.

Drastic measures are needed

However, there are doubts if China can orchestrate a smooth transition. Due to the lack of social security, adequate retirement provisions and broad-based health insurance, the savings rate in China is still at an unprecedented high level: 30% in 2014 according to the Chinese national statistics agency and even 38% according to the OECD (in 2013). While a high savings rate is beneficial for investment, it leads to inefficient allocation of capital. Figure 8 clearly shows that the lion’s share of growth in labour productivity since the 1990s is due to investment in capital. The contribution of total factor productivity (TFP, a measure of the efficiency and effectiveness of the use of labour and capital) to growth is actually negative for the most recent years, which suggests that the Chinese economy has become increasingly inefficient.

Furthermore, business spending on research & development (R&D) as a percentage of GDP in China is in sharp contrast to more developed economies (see Figure 9). China wants to excel in a number of specific technologies and is making great efforts to do so, but for a broad-based innovation that can boost nationwide productivity, much higher investment in R&D across the entire spectrum is needed.

Another problem is that a large proportion of lending by the Chinese banking sector is to state-owned enterprises (SOEs), at the expense of more productive private companies. China does not have a good track record when it comes to high-tech start-ups, and even large companies like Baidu and Alibaba seem to struggle with the fierce competition on international markets.[4] What’s more, the government seems to be reluctant to rapidly reduce the overcapacity in the traditional sectors by means of bankruptcies and mass layoffs, as these could lead to social unrest. Instead, it is talking about acquisitions, reorganisations and debt restructuring with creditors. This means that capital and labour will remain stuck in traditional and unprofitable sectors. Hsieh and Klenow (2009) have calculated that if the efficiency of labour and capital allocation in China were to equal that of the US, productivity of Chinese manufacturing would increase by 30-50%.

[4] Eurasia, Beijing will expand support for emerging industries, but politics will limit progress on innovation, 11 March 2016.

The central question we have attempted to answer in this Special is how fast the Chinese economy is growing and what its potential growth is. Our newly developed China Activity Index (CAI) shows that the Chinese economy suffered a relapse at the beginning of last year and since then has been growing at a stable rate of around 5%. This is one of our indications that China is cautiously engaging in the transition from an investment-driven economy to a consumption-driven economy.

China still has huge potential for growth, and has much room for catching up in terms of labour productivity. The question is whether China will be able to achieve this, given the serious imbalances within its economy. Dealing with these imbalances is more difficult because the government is continuing to target high growth rates, as maintaining economic and therefore social stability has its highest priority. Every time growth seems to drop below levels the government does not feel comfortable with, their Pavlonian response is to issue more debt to keep investments going in traditional growth sectors, such as steel and construction. Moreover, the Chinese government refuses to accept the short-term pain involved with reducing overcapacity through bankruptcies and mass layoffs due to the risk of social unrest. The result is that labour and capital continue to be allocated to inefficient activities. While the government may thus be avoiding a disorderly economic transition, the costs of this stability are rising. Investment is becoming less and less effective, and this is increasingly becoming a brake on growth.