Is China due for a slowdown?

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Is China due for a slowdown?

Bachelor Thesis

Faculty of Economics and Business Bsc Economics and Business

AneteCasno Supervisor: BoeleBonthuis

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ABSTRACT

This paper is written in response to the recent economic slowdown in China. As this country has such a huge influence on global economy and after the recent crisis the world was looking at China as the engine of global recovery, but after quickly returning to its two digit growth rates after crisis, it did not continue for long. After more than 30 years of rapid economic growth, China is experiencing a slowdown. This paper uses the framework of growth accounting as the first step to estimate the total factor productivity and examine which factors drive China’s growth, and then as the second step it analyses current trends in China to see how these factors will grow or decline in the future to predict whether this slowdown is cyclical or permanent. This paper finds that capital and productivity has the biggest contribution to the GDP growth, while labour contribution is relatively small and decreasing. The results this paper presents show that due to the decreasing growth of population, that will soon start to decline, already declining workforce and the shift from investment to consumption led economy the slowdown is considered to be permanent and will lead to a lower long term growth than anticipated. It also stresses the role of government policy to help this transition to happen as smoothly as possible.

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1. INTRODUCTION

1.1 Background

China is the world’s second largest economy, world’s largest manufacturer and exporter, and has been growing rapidly for more than 30 years averaging real GDP growth at about 10 per cent (World Bank and the Development Research Center of the State Council, 2013).In past two years, however, it looks like China could be facing a slowdown. After decades of two digit growth rates it might have started to seem that normal economic rules do not apply for China. While the productivity growth in China at 7.4 per cent is still one of the highest in the world, the rate has been declining since its optimistic return to pre-crisis level on 2010. The productivity growth has fallen by 1.4 per cent from 2011 to 2012, hitting the lowest rate since 1999 (Conference Board, 2013). Different scenarios about China’s future is played out, some predict a smooth change to a lower, but sustainable growth, some a “crash” into stagnation, and as many countries are quite dependent on China’s relatively cheap exports, and many smaller Asian countries depend on China’s imports from them, this is a very relevant topic in the area of economics.One of the most positive outlook on the future has been expressed by, not so surprisingly, one of the estimations that are made by China itself, in the collaboration with World Bank in their China 2030 report, where they predict 8.6 per cent growth until 2015, and 7 per cent until 2020. A more pessimistic view is expressed by Martin Wolf (Wolf, 2013) who predicts 6.5 per cent growth already in 2018-2022, while International Monetary Fund (IMF) projects that the growth in 2013 will be 7.75 per cent (IMF Executive Board, 2013). The government of China states that the growth is within target, which is 7.5 per cent GDP growth, and as Nomura International economist ZhiweiZang said “We believe the government’s policy stance remains unchanged for now as the

slowdown is moderate, but the premier’s speech suggests that the authorities are prepared to take action and fine-tune policy if growth slows more sharply,", which should sound reassuring if not

coming from a country, whose government has always been secretive and reserved in admitting its failures (Reuters, 2013). The country however is in a transition from investment led to a consumption led economy, which comes with lower growth levels. Also, China is in its 12th_{5 year plan and with a}

new dynamic government, whose two out of three priorities are sustainable growth and promotion of domestic consumption,.This raises question – is there need for worry?

1.2 Research aim and the outline

This paper hopes to predict the future path of economic growth in China by evaluating the factors that influence it, with a focus on investigating the current slowdown. Thus the question this paper is answering is whether China is due for a permanent economic slowdown?

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In order to answer this question this paper is organized as follows – section 2 gives a theoretical background, first focusing on growth theories to find the main factors influencing economic growth, knowing these is important forchoosing the right research strategy, and then continues with main views that economists have expressed towards China’s future, concluding this section a number of previous researches on this topic are looked at, focusing on the factors that will most likely influence the growth rate.Section 3 covers methodology, introducing the framework which this paper uses and shows how the data was gathered. Further, section 4 presents findings of this paper, first - the main results - and by evaluating these results,predictions about how the growth rate would move in the future are made. Conclusion sums up what this paper has found, discusses limitations that it had to face and addresses what can be done in the future to have better estimations.

2. THEORETICAL BACKGROUND

While there is no formula for predicting slowdowns, numerous economists have tried to identify the main factors that influence growth. Theory of growth itself has experienced enormous growth, where many economists have made their contributions, to name some -Harrod-Domar model that first included productivity growth, with Solow in 1946, who introduced labour as factor of production, Ramsey in 1928 and later Cass in 1965 who allowed savings rate to change. Now economists have experimented with models that allow for open and closed economies, that look at central banks’ and governments’ influence, that consider human capital and innovation, and that take into account externalities and spillover effects. Growth models have been constantly evolving to adjust to the dynamics of this world that has been experiencing innovations and changes that demand for our views to change in order to be able to make rational predictions about future. This section looks at main growth theories to see, which factors are the most useful for predicting future economic growth, and specifically, which factors are of most importance to China and summarizes previous research done on Chinas growth.

2.1 Evolution of growth theory

To start off this review of different growth models to determine which factors contribute to economic growth and how, it is important to point out why this growth is so essential. Barro and Sala-i-Martin (2004) stresses that economic growth has positive direct effect on standards of living, as well as it has had influence on world income distribution, evening out the distribution, while showing that it also coincides with overall decrease in poverty rates and levels.

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Not to go too deep in the history of mankind and economics, where first classical economists as Adam Smith and David Ricardo dealt with basics of economic growth theory and building blocks of models that are used today, this paper starts with a model that Solowand Swan developed in 1950s. It holds that output is produced with two production factors – labour and capital - assuming constant returns to scale with respect to both factors, and it tries to explain growth with capital accumulation, population growth and technological progress. It differentiates between short-run and long-run, showing that changes in taxes affect output only in short-run and growth is only transitory until a new steady state is reached, the growth rate between steady states is determined by the rate of capital accumulation, which is determined by the savings rate. In the long run there is a steady state that is determined by the growth rate of technology, labour force and the before mentioned savings rate (Solow, 1956). One prediction that this model makes is that the lower the starting level of GDP per capita relative to the steady-state, the higher will be the growth rate, and this might be the most important aspect of this model, as this is widely accepted and found to be true through empirical research. What caused general dissatisfaction with this model is that, although growth rates and investment rates are definitely positively correlated, that is not all that contributes to growth, otherwise without technological change there will eventually be no economic growth (Barro&Sala-Martin, 2004). This led to creations of extensions of this model, as well as other models where created, but this model is still considered as one of the most influential of all times.Even today economists use Solow’s sources of growth – capital, labour and technological level – within a framework of growth accounting to see what contribution to growth each of these make. Growth accounting is a method for computing the rate of technology growth as a residual – the unexplained part of growth after changes in labour and capital have been accounted for. This method will be further introduced in this paper, as it is used for breaking down China’s GDP growth(Barro&Sala-Martin, 2004).

Arrow (1962) and Sheshinski(1967) introduced an interesting idea of spillovers, that is, unintended externalities of investment on the whole economy (Barro&Sala-Martin, 2004). First developed on a smaller scale, meaning that a person’s invention is readily available for everyone due to nonrivalry condition, now can be tied to the theory of the advantage of backwardness - being less developed gives you an advantage to copy the technology at a smaller cost and a faster rate than the pioneering countries did (Nolan &Lenski, 1985). This hypothesis even says that this advantage can allow them to overtake more developed countries, and China has long enjoyed being in “catch up” position having western countries as forerunners. Historical experience shows that the catch-up effect ends when per capita income reaches around $17,000, this is called the middle income trap level, and this is forecasted to happen in China soon after 2015, shifting the growth rate downwards by at least 2 percentage points (Eichengreen et al., 2011). This leads to question whether China is ready to be the new forerunner or losing this advantage of backwardness will slow it down.

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Before this paper looks at predictions made for China’s future, another, more recent theory of economic growth must be introduced. After neoclassical models, there was a need to explain long-term growth, and that is when the endogenous growth models were introduced, where a big emphasis is put on growth due to human capital and research and development (R&D), which allowed returns from capital not to diminish. In these models government has an important role, where it could influence long term growth through its policies. The main problem found in this theory is that it does not predict convergence, but convergence is actually taking place as seen from empirical work. Even research papers that have tried to oppose the idea of convergence, for example, Rodrik (2011) admits that unconditional convergence exists, especially after 1950 in manufacturing and services sectors, he also mentions China as one of the examples of successful convergence.

The more recent work in economic growth has returned to neoclassical roots, incorporating government policies, human capital, diffusion of technology and demographic situation, it supports the idea of convergence, where poorer countries grow faster, and the long-run growth is based on technological growth (Barro, 1996).

2.2 Views on China’s future

The next question that has to be answered is where does China’s future stand, and due to country’s high importance for the rest of the world there are many predictions. Before the main views are looked at, a fact has to be stated – since 2010 when the growth rate was 11 per cent it has fallen to 7.8 in 2012, which is the lowest rate in 13 years. It is safe to assume that there is a slowdown, the question is whether it is cyclical or permanent.

Haltmaier (2013) has identified sources that allowed China to grow so rapidly for more than thirty years and challenges that China is facing now and in the future. She names higher labour productivity as one of the most important factor for the high growth country has experienced, and adds that slowdown in growth of the working-age population and subsequent decline, will have a major impact on the economy. She is also questioning China’s ability to maintain the high investment rate that currently constitutes half of country’s GDP, as investment becomes less productive due to a higher capital/labour ratio. Haltmaier’s (2013) prediction is that until 2030 the growth rate will slow down until 6.5 per cent. She is not the only one that worries about China’s GDP composition (seen in figure 1), country is in a transition from investment- and export- to consumption led economy, which is a natural step in itself, but the question is whether it is going to happen smoothly or abruptly. While China’s National Bureau of Statistics has a positive outlook on the future arguing that consumption currently contributes more than half of GDP growth, National Development and Reform Commission in China on the contrary wrote this March – “The foundation for economic turnaround is not firm.

Consumption is unable to provide a very strong impetus to economic growth, enterprises are less able and willing to invest, and external demand will not change for the better in the near future.”

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(Chovanec et al., 2013). Martin Wolf the Financial Times, (Wolf, 2013) predicts a sharp decrease in the growth consistent with the current slowdown (figure 1 on the rest of the world.

Figure 1: China GDP, structure and growth rates (source: www.ft.com (2013))

As the main reasons for this decline in growth rate he mentions the ones that are already discussed above – middle income trap and catching up with the advanced economies.

in addition to already discussed soon declining labour force, which is happening due to population, and relatively low consumption rates, points out that

inflation, undervalued exchange rates can make slowdown the other hand can be helpful.

All predictions are not so grim, however according to Conference Board’s data

in 1966 and South Korea in 1988, and these countries went ahead to grow with a high rate for seven to nine years and China’s GDP per capita is only 20 per cent of US levels

argues that in near future most of the growth in GDP will have to come from productivity as almost 80 per cent of

economy this number is soon to decline.

from efficiency gains in the sectors as well as from movement from lower productivity to higher productivity sectors, namely shift from agriculture to manufacturing and services (Haltmaier

On an even more positive note, a recent study by Albert Keidel ( economy will surpass United States

possible due to the political reforms, fighting corruption, even going as far as recommending US to rethink its policy and suggesting reforms, and he also says that not only the shift to consumption led economy will happen smoothly, but that in recent decades the success has already been domestic demand driven.

Martin Wolf, the associate editor and chief economics commentator at ) is also concerned with the shift to a lower growth model. predicts a sharp decrease in the growth rate- reaching 6.5 per cent already in 2018 to 2022, which is

ent with the current slowdown (figure 1) and expresses concerns about the implications of that

China GDP, structure and growth rates (source: www.ft.com (2013))

As the main reasons for this decline in growth rate he mentions the ones that are already discussed middle income trap and catching up with the advanced economies.Eichengreen et al

soon declining labour force, which is happening due to and relatively low consumption rates, points out that for China factors like volatile inflation, undervalued exchange rates can make slowdowns more difficult, the openness to trade on , however, Martin Wolf speculates, that there is still space to grow as ’s data, China’s GDP per capita is at the same level as it was in Japan in 1966 and South Korea in 1988, and these countries went ahead to grow with a high rate for seven to nine years and China’s GDP per capita is only 20 per cent of US levels. (Wolf, 2013).Haltmaier

most of the growth in GDP will have to come from increases in productivity as almost 80 per cent of working-age population is already employed, and in China’s

this number is soon to decline. In the past few decades these productivity gains have come from efficiency gains in the sectors as well as from movement from lower productivity to higher

oductivity sectors, namely shift from agriculture to manufacturing and services (Haltmaier

positive note, a recent study by Albert Keidel (2008) predicts that by 2035 China’s economy will surpass United States (US) and be twice its size by 2050. He speculates that it will be possible due to the political reforms, fighting corruption, even going as far as recommending US to rethink its policy and suggesting reforms, and he also says that not only the shift to consumption led ill happen smoothly, but that in recent decades the success has already been domestic the associate editor and chief economics commentator at lower growth model. He reaching 6.5 per cent already in 2018 to 2022, which is and expresses concerns about the implications of that

As the main reasons for this decline in growth rate he mentions the ones that are already discussed Eichengreen et al. (2011) soon declining labour force, which is happening due toageing factors like volatile s more difficult, the openness to trade on , Martin Wolf speculates, that there is still space to grow as el as it was in Japan in 1966 and South Korea in 1988, and these countries went ahead to grow with a high rate for seven to Haltmaier(2011) increases in labour , and in China’s past few decades these productivity gains have come from efficiency gains in the sectors as well as from movement from lower productivity to higher oductivity sectors, namely shift from agriculture to manufacturing and services (Haltmaier, 2011).

) predicts that by 2035 China’s He speculates that it will be possible due to the political reforms, fighting corruption, even going as far as recommending US to rethink its policy and suggesting reforms, and he also says that not only the shift to consumption led ill happen smoothly, but that in recent decades the success has already been domestic

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2.3 Previous research

This section takes a look on what previous research has found when economic models are applied to data in terms of contributions from above mentioned factors to economic growth. Ezaki and Sun (1999) performed growth accounting on China while simultaneously estimating capital stocks and total factor productivity (TFP). They did these estimations for national, regional and provincial scales, and what they found is that China has been able to maintain this high growth for so long due to high and stable capital input, that has contributed 50 per cent to economic growth, while labour contribution has been only 15 per cent and is declining. They argue that higher growth in the East part of China is due to higher capital output.

The Conference Board (2013) takes a different approach to growth accounting, it does these estimations for years 1955 – 2008, and looks at contributions to GDP growth made by TFP, labour quality and quantity, and divides capital into non-ICT and ICT capital. What they find is that non-ICT capital has had the vast majority of contribution, following by TFP, surprisingly the quality of labour hasn’t had a very high contribution, and that might show that there is still some room for improvements.

Bosworth and Collins (2007) also has done growth accounting on China, but they included land and education when estimating contributions, and did it for years 1978 – 2004 for both China and India and compared the two. What is interesting is that their paper divided estimates across primary, secondary and tertiary sectors, and found that TFP has been the most important to industry sector, while employment to services. As the work of Conference Board, they also stress that there could be improvements in quality of labour, namely, that labourers are not highly educated. They also found that TFP has been stable over the years and is not declining as other previous researchers, like, Borenszteinand Ostry (1996) had predicted. While their results are mostly the same as for the above studies, a point worth mentioning, is that they find that agricultural sector still has a significant contribution to growth.

2.4 Factors that will have influence on China’s future GDP growth

After analysing the main growth theories to find out which factors are the most important to economic growth and looking at previous academic research to have a better understanding of which factors could be especially significant to China, this part discusses the factors that have been singled out as the mostinfluential for China’s economic growth in the forthcoming years.

Declining labour and wage increases

One of the main problems China just recently had to start dealing with is decline in population growth that will soon turn to decreasing population, 2012 was the first year when working age population declined (The Economist, 2013). A lot to do with this phenomenon has the drastic one child policy

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China introduced in 1979, that may now be lifted as the most recent ex-president did not use the phrase “maintain a low birth rate” for the first time in ten years, but this would not be an immediate solution, as it takes 15 years for the policy to star showing results, when the new babies enter the labour force, and even then factors like rising costs of raising children might still keep the birth rates low (Li & Wee, 2013). Shen (1998) projected that until 2020 the working age population will be 955.42 million and until 2040 943.15, Banister (1987) is more pessimistic estimating that working age population will arrive at 799.66 million until 2020 and just 505.17 until 2040. As Shen’s work projected that decline in working age population will start declining between 2020 and 2030, and Banister’s work that it should have happened already in 2005 to 2010, most likely the true path is somewhere in between.

China long enjoyed the benefits of “surplus” labour that was employed in primary sector, which was the dominant sector. This way the extra labour could be very cheaply used by manufacturing sector, where it had high contribution margin, giving the employers the opportunity to invest densely in fixed assets, while paying close to nothing to labour and still enjoying huge supply of it (Lewis, 1954). Along with the decrease in the available labour, the real wages for existing workforce goes up, decreasing the comparative advantage of low unit labour costs. That means that investment will experience sharply diminishing returns and will decline, on the other hand the higher wages will increase and enricher the middle class, which will help with the movement from investment to consumption based economy (World Bank and the Development Research Center of the State Council, 2013).

Movement to a consumption based economy

Another reason why investment will have to decrease is that in the past the excess supply could be exported to be consumed outside the country, due to good economic state in western countries, which is no longer the case after the recent crisis. This means that manufacturers will increasingly cater to domestic markets, which are yet not strong enough to absorb all the extra supply, so the total investment will have to decline (Lee et al., 2013). Investment will not only have to decrease, but also move across sectors, if an investment led economy directs most of its investment to manufacturing sector, then a consumption based economy directs it to agriculture and mostly services, for example, education, healthcare. If the government tries to further stimulate investment, it can go down the same way as other countries in history have, when trying to overinvest, for example United States 1920’s expanded heavily industries for automobiles, iron and steel, demand could not match it and that contributed to Great Depression. Government of China has postponed implementing the changes that are needed in order to smoothly shift to a consumption based economy by boosting the economy with cheap credit and undervalued currency (Krugman, 2013).

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Figure 2: Consumption and investment relative to GDP (source: The world Bank (2013), p.13)

The figure 2 above shows what an outlier China is when it comes to consumption and investment to GDP ratio. It is predicted that current investment/GDP ratio of 49 per cent and investment/ GDP o per cent will be 34 and 66 per cent respectively (World Bank and the Development Research Center of the State Council, 2013). China’s government has to make the necessary preparations to smooth out this transition in order to avoid a crash.

Debt concerns

Rising debt in China is another major concern, the foreign debt is reaching 1 trillion US dollars, while it has to mentioned that it has even higher cash reserves as well, as reported by Reuters (Rapoza, 2013), but it comes at the same time as

Inc and Vice Finance Minister’s Zhu Guangyao’s statement that the government local governments’ debt and has not had official figures since 2010 (Reuters 2, 2013 by IMF blames the country for relying on state spending, c

is increasing faster than it is reported, calling the current situation as unsustainable (IMF, 2013). It warns that it is time to stop the credit growth, and use it only if the growth slows very sharply to rebalance.

Human capital

Growth in services sector contribute more and more to the growth in GDP. It is not only the amount of labour and wages that will change, but due to a better education and higher skilled workers across the country there will be a movement

(World Bank and the Development Research Center of the State Council, 2013). This will shift China

stment relative to GDP (source: The world Bank (2013), p.13)

above shows what an outlier China is when it comes to consumption and investment to GDP ratio. It is predicted that current investment/GDP ratio of 49 per cent and investment/ GDP o per cent will be 34 and 66 per cent respectively (World Bank and the Development Research Center of the State Council, 2013). China’s government has to make the necessary preparations to smooth out this transition in order to avoid a crash.

Rising debt in China is another major concern, the foreign debt is reaching 1 trillion US dollars, while it has to mentioned that it has even higher cash reserves as well, as reported by Reuters (Rapoza, ), but it comes at the same time as the yuan-denominated debt is downgraded by Fitch Ratings Vice Finance Minister’s Zhu Guangyao’s statement that the government does not know the cal governments’ debt and has not had official figures since 2010 (Reuters 2, 2013). A recent report by IMF blames the country for relying on state spending, credit and investment, and for the debt that is increasing faster than it is reported, calling the current situation as unsustainable (IMF, 2013). It warns that it is time to stop the credit growth, and use it only if the growth slows very sharply to

in services sector contribute more and more to the growth in GDP. It is not only the amount of labour and wages that will change, but due to a better education and higher skilled workers across the country there will be a movement of workers to services sector, as can be seen in the figure below (World Bank and the Development Research Center of the State Council, 2013). This will shift China above shows what an outlier China is when it comes to consumption and investment to GDP ratio. It is predicted that current investment/GDP ratio of 49 per cent and investment/ GDP of 47 per cent will be 34 and 66 per cent respectively (World Bank and the Development Research Center of the State Council, 2013). China’s government has to make the necessary preparations to smooth out

Rising debt in China is another major concern, the foreign debt is reaching 1 trillion US dollars, while it has to mentioned that it has even higher cash reserves as well, as reported by Reuters (Rapoza, downgraded by Fitch Ratings does not know the ). A recent report redit and investment, and for the debt that is increasing faster than it is reported, calling the current situation as unsustainable (IMF, 2013). It warns that it is time to stop the credit growth, and use it only if the growth slows very sharply to

in services sector contribute more and more to the growth in GDP. It is not only the amount of labour and wages that will change, but due to a better education and higher skilled workers across of workers to services sector, as can be seen in the figure below (World Bank and the Development Research Center of the State Council, 2013). This will shift China

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from labour based to knowledge based economy, possibly closing the gap of declining workfo further increasing the wage level.

Figure 3: Changing structure of employment (source: Beyond Economic Growth (2000), p.51)

The extent of this will highly depend on growth in human capital, which has increased three times through the years 1985-2007, and especially after 1994, when it grew on average 7.64 per cent a year (Li et al, 2010). Their paper also showed that human capital is much higher and growing faster in urban areas (growth gap – 4.29 per cent per year), which can be expla

income, access to better education and health care. Over the next 20 years the urbanization process will grow rapidly, each year the amount of new urban population will equal more than on Tokyo or Buenos Aires, in 2030 nearly two thirds of population is estimated to live in urban areas (World Bank and the Development Research Center of the State Council, 2013). This implies that there is still a lot of space for improvements in this area, and while human capital has grown during th

China, it has not grown as much as physical capital has. If China manages to increase human capital and move into knowledge based economy, it could overcome the possibility of falling into middle income trap.

Technology

Due to increasing income per capita China is losing its advantage of backwardness, position that from labour based to knowledge based economy, possibly closing the gap of declining workfo

: Changing structure of employment (source: Beyond Economic Growth (2000), p.51)

The extent of this will highly depend on growth in human capital, which has increased three times 2007, and especially after 1994, when it grew on average 7.64 per cent a year (Li et al, 2010). Their paper also showed that human capital is much higher and growing faster in 4.29 per cent per year), which can be explained by higher per capita income, access to better education and health care. Over the next 20 years the urbanization process will grow rapidly, each year the amount of new urban population will equal more than on Tokyo or thirds of population is estimated to live in urban areas (World Bank and the Development Research Center of the State Council, 2013). This implies that there is still a lot of space for improvements in this area, and while human capital has grown during the rapid growth of China, it has not grown as much as physical capital has. If China manages to increase human capital and move into knowledge based economy, it could overcome the possibility of falling into middle

income per capita China is losing its advantage of backwardness, position that from labour based to knowledge based economy, possibly closing the gap of declining workforce, but

The extent of this will highly depend on growth in human capital, which has increased three times 2007, and especially after 1994, when it grew on average 7.64 per cent a year (Li et al, 2010). Their paper also showed that human capital is much higher and growing faster in ined by higher per capita income, access to better education and health care. Over the next 20 years the urbanization process will grow rapidly, each year the amount of new urban population will equal more than on Tokyo or thirds of population is estimated to live in urban areas (World Bank and the Development Research Center of the State Council, 2013). This implies that there is still a lot e rapid growth of China, it has not grown as much as physical capital has. If China manages to increase human capital and move into knowledge based economy, it could overcome the possibility of falling into middle

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This “catch up” position contributed highly to growth in past decades, now China is faced with either becoming the new forerunner in the field or lagging behind just enough to not be able to copy technology. This will also be highly dependent on human capital and government policies. As the future success in technology is correlated with inputs in research & development (R&D), it is worth looking at the growth in R&D. 2012 study shows that during years 2000 – 2010 R&D expense increased almost 8 times, R&D/GDP ratio doubled and patents approved increased almost ten times (Wang and Hong, 2012). Which is a high number when compared with US where patent granted during the same years increased only 1.4 times (U.S. Patent and Trademark Office, 2013). This indicator shows that China is on the right path to become the new leader in innovation.

Environmental pressures

Another factor that has to be taken into account that has been become increasingly important in recent years is the environment. China has been facing pressure from the western countries to “go green” or at least “greener”, currently China’s development pattern includes heavy use of natural resources, water, land and air. If it were to take seriously these environmental concerns and consider adopting green technologies and limit pollution, the industry share of GDP would go down, as well as the share of resource and pollution intensive firms in the manufacturing sector would decrease along with the price increase for energy and commodities (World Bank and the Development Research Center of the State Council, 2013).

While the estimates of China’s future growth are constantly done through various methods and models, and this is not the first paper to do that, this slowdown is a relatively new trend, ongoing for 2 years now, and every quarterly data gives something new, and the estimates are constantly downwards adjusted, because economists still keep waiting for China’s growth rate to go back to its ‘usual’ highs. Also, most of the research is done before 2000, and those estimations are not relevant currently. This paper tries to use the most current data and future estimates to answer whether there is a permanent slowdown in China’s economy and if so, is it going to happen smoothly or abruptly. Another contribution it tries to make is to use data not only on total labour and capital, but divide it further across three sectors – agricultural, manufacturing and services – to see where the increases in future growth could be coming from.

3. METHODOLOGY

3.1 Research strategy and framework

Knowing China’s important role in the global economy, it is important for policy makers to make necessary preparations in case the slowdown in China’s economy is going to be permanent. Vast

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majority of growth theories and previous research stresses out the importance of labour, capital, and technology diffusion. To measure the contribution of changes in capital, labour and production technologies (which is residual growth that is not captured by production factors), to economic growth in China, the framework of growth accounting, first developed by Solow (1956) and further developed by Barro, is used. This is used as a first step of the analysis, furthered with exploration of factors that could influence these changes in capital, labour and productivity to examine and project where the growth rate would move in the future.

To start the analysis the simple production function is used: Y = F(A,K,L)

Where Y is the real GDP, A is the measure for TFP, K the physical capital stock, and L the quantity of labour. This paper uses Cobb-Douglas production function, which exhibits constant returns to scale:

F(tK,tL) = A _{⋅ (tK)}Sk_{⋅ (tL)}Sl_{= t}_{⋅ F(K,L)}

Where t is the factor by which the production factors are multiplied, sK and sLshares of income for

capital and labour, where sL= 1 - sK.In this paper the shares of labour and capital income are allowed

change over time and the production factors get paid their marginal products.The equation can be rewritten in terms of growth rates by taking logarithms and fully differentiating both sides:

g =a -sK⋅k -sL⋅ (l)

Where g is the growth of real GDP,a is the growth rate of total factor productivity, k the growth of physical capital, l of quantity of labour and sKand sLshares of income for capital and labour.

Now the growth rate of output is decomposed in growth rates of physical capital, labour and productivity. Further this paper tries not only to estimate the contribution from capital and labour to GDP, but divides these production factors in three sectors – agriculture, manufacturing and services, as is it often argued that a substantial part of the high growth rate has come from movements across these sectors and that this movement has limits.

3.2 Data

Overall, the biggest problem this paper has to face is accessing reliable data, as the data publicly available is outdated. The most current data does not come from academic literature or China’s officials, but are estimations by organizations like World Bank and IMF, although that can be seen as an advantage as well, as China is known for manipulating its data to hide country’s weaknesses. GDP data

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GDP levels and growth rates comes from the World Bank for the years 1980-2012. Labour

As there is no reliable collection of number of hours worked for China, this paper uses number of persons employed on average per year. The data used for employment and labour share of income comes from the Conference Board. The labour then is further divided in 3 sectors - labour in agriculture, industry and services, the specific fractions for 1980-2010 are available in World Bank database.

Physical capital

Capital stock data gathering causes some problems as no capital stock is officially reported by China’s officials. Therefore this paper uses estimates by Yanrui Wu (2009), as he has also divided capital stock by the same three sectors. The method he uses for estimating the stock is the conventional perpetual inventory method:

Kt= (1 – δ) ⋅ Kt-1 + It

Where K is the capital stock, δ the depreciation rate and I – the new investment. The equation can be converted to:

Kt= ∑(1 – δ)k⋅ It+ (1 – δ)t⋅K0

This way the capital stock can be estimated knowing the initial capital stock K0 and the depreciation

rate δ. Wu uses different depreciation rates in different regions and sectors, author’s estimates for depreciation rates can be seen in figure 4. These capital estimates, however are only available until year 2006, for further capital stock series this paper uses own estimates, with investment from World Bank fixed capital formation data.

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4. FINDINGS

4.1 Results

Applying the framework of growth accounting this paper obtains the estimates of TFP as can be seen in Table 1. The previous literature had emphasised the importance of TFP in China’s growth, therefore it was expected that the growth rate of productivity will be high throughout the years, and that is generally the case with the exception of 3 years –1989, 1990 and 2009. The results were close to the ones Bosworth and Collins (2007) has estimated, where TFP has been somewhat steady over year and not declining, the decrease in 2012 is a worldwide phenomenon and not specific to China. It can also be seen that the total labour growth rate has a decreasing tendency, while total capital growth rate is slightly increasing over time. When divided in sectors, growth labour in agriculture is very close to zero and even negative in many years, the growth in manufacturing and services on the other hand is positive, although with a small tendency of decreasing. When it comes to capital growth rates, they are high over all sectors and especially in services.

Table 2 shows the income share for labour and capital, further divided by the same sectors. The patterns can be easily seen – while labour share of income is slowly declining, there is also a shift across the sectors. Labour compensation in agriculture has decreased from almost 36 per cent in 1980 to only 14% in 2012, in the meantime labour share for services has increased significantly from only 6 per cent to 15 per cent. While total capital share is slowly increasing, when it comes to sectors, exactly the same movement from agriculture to services can be noticed, while the capital for manufacturing has held a steady share – around 26 per cent.

Graph 1 shows the contribution of labour, capital and productivity to the growth rate. Here the trends can be easily seen – contribution of labour is steadily decreasing, while the capital contribution is increasing. In 1980 labour contributed 18 per cent and capital 45 per cent, in 2012 on the other hand labour contributed only 2 per cent and capital 78 per cent. The productivity has had a quite high contribution over years averaging on 30 per cent. The number would be higher if not for the three exception years (1989, 1990 and 2009), where the negative amount is possibly due to data estimation errors. These numbers indicate that in the future the economic growth, will have to come either from increases in capital or productivity, because the labour force will decline.

Graph 2 does the same estimation of contributions to GDP growth, but this time it divides labour and capital in agricultural, manufacturing and services sectors. Labour in agriculture has a negative contribution in vast majority in years while labour in manufacturing and services has a positive

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capital in agriculture has a very little contribution averaging 3 per cent over years, while the contribution from growth of capital in services has the highest contribution averaging 28 per cent, which reaffirms the trend that higher income countries shift higher fraction of their GDP to tertiary sector. The productivity estimates are the same.

4.2 Discussion

The cooperative project between the World Bank and China itself (World Bank and the Development Research Center of the State Council, 2013) predicted that with steady reforms and without major shocks the growth rate would be 8.6 per cent for years 2011-2012, but the actual rate for 2012 was 7.8 per cent, showing that this slowdown is happening more rapidly than anyone expected. This section links the factors from section 2 that were said to have the most importance for China’s economic growth and the results from the growth accounting framework to answer the question this paper placed in the beginning – will this slowdown in China be only temporary or permanent?

Finally, the quantitative part and the analysis is put together in order to make predictions about China’s future. One of the main factors mentioned in the theoretical background is the declining work-force and soon also the population. It can be seen that labour growth rates in agriculture and services sectors have been declining steadily, especially since 2000; labour growth in agriculture has even turned negative. It can also be seen that labour contribution has experienced shift from agriculture and manufacturing to services sector, and with agriculture no longer being the dominant sector the wages also increase. Higher cost labour will continue the trend of declining contribution from this production factor and China will keep losing one of the main advantages that it used to enjoy.The labour growth in manufacturing however has been quite steady, but this is now also endangered as the manufacturing sector may soon start to shrink due to the continuing shift to the services sector. The conclusion from evaluating the labour growth and its contribution to GDP growth is that the slowdown will be permanent.

It might not be that huge of a problem if an increase in growth of capital or productivity could be expected to offset the decreasing labour growth. In the case of capital growth – historically it has had the highest contribution to the growth of GDP, but it has been decreasing through years 1980-2012, not as much as labour, but still decreasing. The reasons for this have been discussed above, but to sum up the main ones, the movement from investment to consumption based economy has to be mentioned. This is along China’s government’s plan, but as the manufacturers cater more and more to domestic market, the capital intensive firms will be have to re-focus to less capital intensive production/services. From the growth accounting results it can also be seen that there is a shift across sectors, corresponding to this movement to consumption based economy – the contribution from capital in services has increased rapidly. Another reason that will have a negative effect on capital

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growth is the previously discussed environmental pressures, which can lead to movement from capital intensive to labour intensive sectors, which will lead to intensified problems due to declining work-force. It is safe to argue that when it comes to capital growth and its contribution to China’s economy, it looks like the growth rate is permanently shifting to a lower level.

Productivity growth, however, has been steady and the contribution from it - high, here one of the most important factors is increasing human capital, which is also in line with the growing services industry, as countries with higher skilled workers tend to have a very large services sector.Human capital is likely to grow steadily through next decades due to higher income per capita, better health care and education, as well as China is rapidly urbanizing, and urban areas have higher incomes and better education. It can be expected that productivity growth will stay on the current levels and might be the driving force of China’s economy. This is also supported by previously mentioned increases in R&D expenditures and growing number of patents, which accommodates technological innovation. To sum it up, the main conclusion is that China is experiencing a permanent slowdown, which is happening faster than it was anticipated, and the economy will continue to slow down even more, although it is impossible to make a precise estimate to at what rate the slowdown will stop. Whether it will happen smoothly or abruptly depends on whether the China’s government will be able to implement the right policies to accommodate a knowledge based and consumption led economy. The main reasons for stating that the slowdown is permanent is the declining workforce, movement of capital and labour to services industry, where it is less productive and decline in investment, through its path to consumption led economy.

5. CONCLUSION

This paper used the framework of growth accounting for years 1980 - 2012 as the first step to estimate the total factor productivity and examine which factors drive China’s growth, and then as a second step it analysed current trends in China to see how these factors will grow or decline in the future to predict whether this slowdown is cyclical or permanent. This paper found that capital and productivity has the biggest contribution to the GDP growth, while labour contribution is relatively small and decreasing. The main result this paper presents showed that due to decreasing growth of population, that will soon start to decline, already declining workforce and shift from investment to consumption led economy the slowdown is considered permanent and will lead to lower long term growth than anticipated. It also stressed the role of government’s policy to help this transition to happen as smoothly as possible.

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In addition to just looking at the contributions from labour, capital and productivity, it also looked at differences in three sectors – agriculture, manufacturing and services, finding that both labour and capital is decreasing in agriculture, while both are increasing in services sector, having a high contribution to GDP growth. Contribution from growth in manufacturing has always been quite high, but now is starting to slowly decline.

The analysis of current economic and also demographic situation showed that factors like growing middle class, human capital and urbanisation will contribute to economic growth, while declining working age population, loss of comparative advantage of low cost labour and the loss of the advantage of backwardness will slow it down. The role of the government will therefore be crucial to try to balance these negatives against positives.

The main problem that this paper had to face is the data reliability and accessibility, as the data for most recent years is difficult to come by, and even the one that you can find does not come from academic literature, but are estimations made by organizations like World Bank and IMF. All data coming from China faces another problem, which is that the country is known for data manipulation, to show itself in a more positive light. The estimations made by economists and organisations from the rest of the world vary by their methods and have substantial differences in their results, and when it comes to China, the numerical values are very large and even a small difference in data makes for a significant difference in estimations. For subsequent researches in this topic, another important point would be to include a measure for human capital in production function, as many economists have emphasised its importance for growth, but as the data for this measure would have to be estimated in a speculative way and would not be very reliable this was not done in this research.

General consensus is that there is a shift in China to a lower growth level, which can be challenging in today’s global economy, which is dealing with uncertainties of post-crisis phase. A successful transition can mean growth at a healthy pace for many years achieving higher income and evolving into a high-income country. This is the outcome that not only China itself hopes to achieve, but also the rest of the world, but without necessary reforms the country’s growth rate will decline sharply trapping it into middle income level long-term. These country’s future heavily depends on the new government’s policies.

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APPENDIX

Table 1 – Growth rates 1981-1989 1990-1999 2000 -2009 2010 2011 2012

Growth rate of China's

GDP 9.75% 9.99% 10.29% 10.40% 9.30% 7.80% Growth rate of labour Total 2.87% 1.22% 0.62% 0.37% 0.41% 0.40% Agriculture 1.30% -0.57% -2.07% -3.32% -3.51% -3.32% Manufacturing 4.97% 1.87% 2.60% 3.61% 4.26% 3.84% Services 6.98% 5.23% 3.04% 1.84% 2.39% 2.25% Growth rate of capital Total 10.27% 12.19% 12.64% 11.69% 9.58% 10.40% Agriculture 4.78% 8.10% 9.31% 8.61% 7.05% 7.65% Manufacturing 10.31% 12.01% 11.83% 10.98% 8.99% 9.76% Services 12.62% 13.45% 14.13% 12.83% 10.51% 11.40% Growth rate of TFP 3.37% 3.69% 3.08% 3.46% 3.56% 1.55%

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Table 2 - Production factors’ shares 1981-1989 1990-1999 2000 -2009 2010 2011 2012 Labour share 52.61% 53.65% 45.78% 41.89% 41.89% 41.56% Agricultural labour share 33.61% 29.05% 20.82% 15.37% 14.77% 14.11% Manufacturing labour share 10.64% 12.14% 10.97% 12.02% 12.48% 12.81% Services labour share 8.35% 12.46% 13.99% 14.49% 14.78% 14.93% Capital share 47.39% 46.35% 54.22% 58.11% 58.11% 58.44% Agricultural capital share 6.53% 3.79% 3.31% 2.98% 2.91% 2.86% Manufacturing capital share 25.19% 25.53% 27.79% 28.71% 28.55% 28.54% Services capital share 15.67% 17.02% 23.12% 26.42% 26.65% 27.04%

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Graph 1 - Contribution to GDP from capital, labour and TFP

Graph 2 - Contribution to GDP from different sectors

-10.00 -5.00 0.00 5.00 10.00 15.00 20.00 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 Contributions to GDP Growth

Contribution from labour Contribution from capital Contribution from TFP

-6.00 -4.00 -2.00 0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 1 9 8 0 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2

Contributions to GDP from Different Sectors

Contribution from labour in agriculture Contribution from labour in manufacturing Contribution from labour in services Contribution from capital in agriculture Contribution from capital in manufacturing Contribution from capital in services Contribution from TFP

Is China due for a slowdown?