Its economy will soon exhaust its sources of easy productivity gains.
By Daniel Rohr, CFA | 10-04-17 | 06:00 AM | Email Article

This article continues our series on China’s next 10 years. Previously, we discussed how a reversal of prior demographic trends would reshape the economy in the decade to come. Forthcoming articles will address productivity, rebalancing, and debt.

Daniel Rohr, CFA, is director of basic-materials equity research for Morningstar.

Ever since China’s economy began to slow from last decade’s double-digit pace, investors have quarreled over the country’s growth prospects. At various times, bulls and bears have each glimpsed apparent victory, only for a reversal of China’s credit cycle to hand narrative momentum to the other side. The long-term outlook remains unsettled, and the debate continues.

Perhaps no question matters more to investors globally. Over the past 10 years, China has been the single largest contributor to global GDP growth, accounting for nearly one third of the world total. Meanwhile, China has become the world’s biggest buyer of everything from automobiles to airplanes to oral hygiene products.

Estimating the Sources of Chinese GDP Growth
In pondering the long-term trajectory of China’s economy, it’s instructive to first consider the underlying sources of the country’s slowdown. Why, exactly, has growth slowed?

To answer that question in an empirical fashion, we begin with a breakdown of GDP into its constituent parts. At the most basic level, a country’s economic output can be thought of as a product of three inputs: capital, labor, and total factor productivity. An economy grows by accumulating capital (for example, a new factory is built), adding labor (the factory hires unemployed workers), or increasing productivity (the factory adopts a new technology).

We can use this standard framework (specifically, a Cobb-Douglas production function) to estimate the contributions of capital, labor, and productivity to China’s GDP growth. To identify secular shifts in China’s growth pattern, we focus on average annual growth rates for each of the past three decades (1991-2000, 2001-10, and 2011-16) rather than year-by-year estimates.

Faltering productivity appears to explain much of the economy’s deceleration. We estimate average productivity growth at 2.3% in the current decade, down from 4.8% in the 2000s. Weaker productivity gains account for roughly three fourths of the total decline in GDP growth over this interval.

Meanwhile, the economy has become increasingly dependent on capital accumulation as a source of growth. Since 2010, net capital additions have accounted for nearly 70% of GDP growth, up from roughly half in the prior two decades.

While the contribution from labor supply growth has slipped in the current decade, the decline played little direct role in slowing overall GDP growth. As discussed earlier in our series on China’s next 10 years, changes in labor supply have had, and will continue to have, a larger impact on the composition of GDP than on its size--shifting income to households from corporations and lifting consumption at the expense of savings and investment.

Why Has Productivity Growth Faltered?
Why is China finding productivity gains harder to come by? Mainly because the conditions that made rapid productivity growth possible in the post-Mao era no longer exist.

The World’s Greatest Imitator Must Become an Innovator
First, China is no longer a technologically “backward” country that can generate comparably easy productivity gains by copying more sophisticated foreigners.

Arguably, no major country has capitalized on the opportunity afforded copycats as well as China. Rapid absorption of foreign technology is evident in the growth of the country’s now world-beating manufacturing sector, which now claims a roughly 20% share of global manufacturing exports, up from 5% in 2000 and 2% in 1990. China’s success as an imitator is attributable to four interlinked factors: fortunate timing, an ideal location, strong government support, and a vast domestic market.

While China’s rapid technological catch-up has proved a major boon to growth over the past few decades, it naturally leaves less scope for productivity-enhancing copycat behavior going forward. Increasingly, Chinese firms will need to innovate rather than imitate. And that’s a lot harder to do.

The Rural Labor Surplus Is Drying Up
Second, having urbanized and industrialized at a pace possibly unprecedented in human history, the scope for boosting productivity by moving ever more farmers to factories or storefronts is now more limited.

Academics studies suggest that China’s agricultural workforce now accounts for less than 20% of the total workforce. Meanwhile, labor migration to urban areas has slowed by half in the past several years, and the population of migrant workers under 30 years old has been declining since 2008.

This isn’t to say that Chinese farmers will stop moving to cities, only that fewer will make the trip in the years to come. That implies additional downward pressure on productivity growth. It also means decelerating urbanization.

Looking ahead, changes to China’s labor mix will increasingly involve moving workers from the industrial sector to the service sector. This process has already begun. Industrial employment peaked in 2012 and has been slipping ever since.

But the reallocation of labor from industry to services will generate far less productivity growth than the shift out of agriculture. Chinese labor productivity is actually slightly higher in industry than in services.

High-Return Projects Will Get Even Harder to Find
Third, decades of rapid capital accumulation have left China with far fewer high-return projects than were available at the dawn of the reform era.

Impressively, despite enormous additions to the capital stock, economywide returns on investment remained high throughout the 1980s, 1990s, and most of the 2000s. This was partly due to decades of economic mismanagement under Mao, which left China with an especially paltry capital stock and a correspondingly ample array of promising investment opportunities. More important, however, were continued reforms that boosted prospective returns and improved capital allocation.

Since 2008, however, returns have faltered due to repeated stimulus and stalled reforms. China’s total capital output ratio, which measures how efficiently the country’s total capital stock is being put to use, has deteriorated amid overinvestment across vast swathes of the economy.

China’s incremental capital output ratio, which measures how efficiently new capital is being put to use, looks even worse. China currently generates 50% less GDP for each new unit of capital than it did in 2007.

Today’s China can no longer rely on brute capital accumulation as a major source of productivity gains. If anything, maintaining the current level of spending would probably reduce productivity growth.

The Demographic Window of Opportunity Is Closing
Fourth, China’s “demographic dividend” has been spent.

China’s family planning laws, beginning with the “Triple L” policy in the 1970s, triggered a premature drop in fertility and unusually large demographic dividend. From 1970 to 1980, China’s total fertility rate plunged from 5.7 to 2.6 births per woman, an unprecedented decline for what was still a poor and largely agrarian country. While that led to an immediate slowdown in population growth, the working-age population continued to expand, from 582 million in 1980 to nearly 1.0 billion by 2010. Over that time, China’s support ratio--the number of working age adults per dependent--surged from 1.5 to 2.9. As theory would predict, China’s household saving rate surged, facilitating especially rapid (and, for a long time, productivity-enhancing) capital accumulation.

Persistently low fertility has prematurely closed China’s demographic window of opportunity. The working-age population has already begun to contract. The demographic support ratio, while still high, has begun to slip, and so too has the household saving rate.

Over the next 10 years, China’s support ratio will fall to 2.3. For every 10 dependents, China will have 4 fewer working-age adults than it does today. The household saving rate is likely to fall further, draining the pool of funds available for productivity-enhancing investment.

How Much Further Will Productivity Growth Fall?
The next 10 years will see each of the four conditions that aided the reform era’s outsize productivity gains approach exhaustion. Technological progress will decelerate as firms must innovate rather than imitate, urbanization will slow as the rural labor surplus is exhausted, returns on capital will deteriorate as overinvestment makes high-return projects ever scarcer, and the country’s demographic window of opportunity will close. Productivity growth is likely to slow from its recent pace of about 2.3%, dragging GDP growth down with it.

But by how much? History offers some clues. Over the past five decades, the typical country at China’s rung on the income ladder generated 0.7% average productivity growth in the subsequent 10 years. Notably, less than one fourth of those countries enjoyed the 2%-plus annual gains implicit in consensus forecasts for China.

More ominous is the possibility that productivity growth utterly stagnates--roughly one third of countries at China’s income level saw flat to negative productivity growth for an entire decade. Academic research suggests flatlining productivity is especially common among previously fast-growing middle-income countries, a phenomenon economists refer to as the middle-income trap.

Will China Fall Into the Middle-Income Trap?
Next up in our series on China’s next 10 years, we’ll examine the historical experience of countries that fell into the middle-income trap (and those that escaped) in search for clues about China’s road ahead. By how much, for example, does growth tend to slow once a country achieves middle-income status? Are there any attributes that make a sharp slowdown more or less likely? Why does it appear to be getting harder for middle-income countries to avoid the trap? Ultimately, we’ll aim to gauge the risk that China falls into the trap itself.

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