Chinese economy has maintained nearly 10 percent growth rate during the past 30 years and become the second largest economy today. Because in modern history there’s no other country has achieved this great accomplishment in just few decades, people either show complacency, believing the high growth rate will last forever, or express anxiety, worrying the march step may stop suddenly and the good days will be over. Last year, the mainstream feeling of both policy makers and economists is complacency; but in this year, anxiety dominates people’s mind. A good few of economists believe Chinese economy is at its turning point.
1.The Story of Chinese Economic Success
Before discussing the turning point of Chinese economy, let’s review the story of Chinese economic success. In this regard, there are many different versions. Among them, the most inspirational one is to begin with the demographic transition.
Demographic transition begins with decline of mortality, expansion of life expectancy and subsequent decline of fertility. In the first phase of demographic transition, the total dependency ratio will decrease and working-age population ratio will rise. In China, demographic transition starts at the end of 1970s and the working-age population ratio exceeds the world average level in 1978- the year when economic reform begins. In 2010, it reaches more than 72 percent, 7 percent higher than world level.
Under a suitable policy environment, demographic transition will translate itself into demographic dividend through some mechanisms. The first mechanism is labor supply effect: more working-age population, more labor. But, only by economic reform can this labor go into non-agriculture industries which have much higher labor productivity than that of agriculture. So the more the reform is, the higher the share of non-agriculture employment is, and the faster the growth rate is. From 1978 to 2010, the share of non-agriculture employment (the ratio of non-agriculture employment to total employment) rises from 30 percent to more than 63 percent. During this period, 1 percent rise of working-age population ratio results in 2.3 percent rise of non-agriculture employment share. We call this phenomenon as “labor transition”.
The second mechanism translating demographic transition into demographic dividend is capital formation effect: more income, more saving and investment. From 1978 to 2010, the saving rate and investment rate goes from 35 percent to 53 percent and 48 percent respectively. During this period, 1 percent increase of working-age population ratio is accompanied by 1.2-1.5 percent increase of saving rate and 1 percent of saving rate rise will bring 0.5-0.6 percent rise of investment rate. There’s nothing new about capital formation in the process of demographic transition. For example, from 1840 to the end of 19th century, investment rate is as high as 30 percent in America and saving rate of America is the highest in the world(Davis, L.E., Gallman, R.E., 1994. Savings, investment, and economic growth: the United States in the nineteenth century. In: James, J.A. Thomas, M., (Eds.), Capitalism in Context. University of Chicago Press, Chicago, IL, pp. 202-229.). In fact, capital formation may be a more fundamental factor for economic growth. Taking India as an example, in 1980s, India’s GDP per capita is higher than that of China. But since 1990s, China has surpassed India and China’s GDP per capita is nearly 3 times of India in this century. The different performance is mainly due to different saving/investment rate: China’s saving/investment rate is about 1.6 times of that of India, while working-age population ratio just 1.1 times of that of India.
In short, through labor supply effect and capital formation effect, demographic transition eventually brings in demographic dividend. Neglecting agriculture department, then the GDP per capita is equal to product of GDP per non-agriculture employment, non-agriculture employment share and working-age population share, so the demographic dividend can be decomposed into three components: capital formation effect, labor transition effect and demographic effect. Of course, the technology progress I have not mentioned is embedded in the capital formation and labor transition effects.
2.The Turning Points
Now the turning points are coming. First one is Lewis turning point. According to Arthur Lewis’s famous paper (Lewis, 1954), in developing countries, this point happens when unlimited labor supply disappears and labor cost begins to rise. In later discussion, Rains and Fei (1961) further divide Lewis turning point into two points: shortage point when wage rises but at a moderate speed, and commercialization point when wage rises at an accelerating speed.
For China, the shortage point has already set in. Comparing wage growth rate of urban collective-owned units with GDP growth rate, before 1998, the former was lower than the latter; but after 1998, the gap has narrowed and in some years wage even rises faster than GDP. So it’s safe to say the shortage point happens at least in the mid of the first decade of this century and recent signs in labor market show the commercialization point is coming.
The second is demographic turning point. As we have discussed, in the first phase of demographic transition, working-age population ratio increases. But in the second phase of demographic transition, as baby boomers aging, the working-age population ratio will first lose its rising momentum- we call the slowdown of growth rate of working-age population as the first-order demographic turning point, then will decrease in level when its growth rate becomes negative- we call this change as demographic level turning point. In China, the first-order turning point happens in 2003, and according to World Bank’s projection, the level turning point will come at 2015.
The third is saving/investment turning point, i.e. the point where saving rate and investment rate decrease. Of course, in an open economy, domestic investment rate needs not to match exactly domestic saving rate. But for most of countries, investment rate must have a same trend and track as that of saving rate because any major and long-term deviation will almost always cause crisis- such as United States and Spain.
So will China face with this third turning point? Let’s look at the saving structure of China. The latest data of flow of funds shows, in 2008, the saving rates of household, non-financial business and government are 23%, 20% and 8% respectively. That is, household sector saving accounts for just 45% of total saving, while the share of non-financial business and government saving is as high as 55%.
In aging process, household saving rate may or may not decrease. In Japan, the saving rate of household decreases from more than 12 percent in 1991 when its working-age population ratio reaches the highest nearly 70 percent, to about 2 percent in 2008. But in Germany, different case exhibits. At the same period, share of working-age population in Germany decreases from 69 percent in 1991 to 66 percent in 2008- the same size of decrease as that of Japan, but household saving rate remains 10 to 12 percent.
But the saving rate of non-financial business sector and government sector will probably or almost definitely go down because the Lewis turning point and demographic turning point. Besides increasing labor cost, business sector’s saving will also be eroded by the more expensive capital. For instance, in stock market, the average cash dividend rate of China only 2 percent, while in United States it’s 9 percent. The situation will change if households have less saving in the future and are less willing to take risk during aging process. The government sector’s saving will also be impacted because, at first, the government revenue is highly pro-cyclical so that slowdown of economy will cause decelerating growth of it, and second, nearly 1/5 income of local government comes from land sale which has already been stricken by sluggish housing market.
3.Lessons, Challenges and Opportunities
Since the story of past economic success results from demographic dividend, the turning points in the second phase of demographic transition will, therefore, result in economic slowdown. But slowdown per se is not something we should worry about too much because the base is much bigger than past. Today’s GDP is more than 30 trillion RMB, so the 7 percent growth rate will produce more than 2 trillion increase of GDP which is 2 times of that of past when GDP was 10 trillion RMB and growth rate was 10 percent.
What we should worry about is sudden stop, hard landing or even crisis associated with turning points. In fact, the background of today’s global crisis is the simultaneous turning points. In 2007, demographic level turning point and saving rate turning point come across to high-income countries coincidently and one year later, in 2008, global crisis occurs. The advent of turning points and occurrence of crisis is not a coincidence. For example, in Japan, demographic first-order turning point and level turning point happens in 1988 and 1993 respectively while saving/investment turning point in 1990. Japan’s bubble bursts in 1990 and after that, the Japanese economy enters into a long-term stagnancy. In United States- the origin of today’s global crisis- and Spain- the center of Euro crisis, the turning points appear around 2006 and 2005. The only high-income country that has not stricken by the crisis is Germany which has not experienced turning points because its saving rate is very stable.
So, why do turning points predict crisis so precisely? The first lesson is housing bubble. The demographic turning point means the decline of demand for housing and the end of bullish housing market. In Japan, urban land price collapses in 1990, 2 years after the demographic firs-order turning point and 3 years before level turning point. In United States, house price collapse in 2006- the exact year of level turning point. The second lesson is credit boom at the time of saving turning point. Japan, United States and Spain, all these three countries witness credit boom when saving rate decrease. Germany- the only country that has no crisis- controls credit better obviously.
Other countries’ lessons are China’s challenges. The first challenge is possible housing bubble. But the question is: while in the past few years many economists have predicted that the bubble is going to burst due to too high price, there’s nothing of that kind happened, although there’s price adjustment in some cities. One of possible answers is supply shortage in market. For instance, in last year, 12 million new household arise in urban area, but the number of completed new housing unit is only 6 million- supply is only 50 percent of demand. At the same time, in urban area, per capita floor space of residential building is as high as nearly 32 square meters- higher than many developed countries, such as Japan. The co-existence of high per capita floor space and supply shortage reflects the structural problem in China’s housing market: construction enterprises are more willing to build big, luxury apartments and houses for upper-middle income and high income families, but there’s less supply of small, affordable apartments for new citizens who move from countryside or just graduate from university.
The second challenge is for banking sector. Since 2009, China’s banking sector has churned out huge amount of credit- in total 55 trillion loans today, nearly half created in past three years. The turning points will present two problems for this credit boom: first, the non-perform loan may rise in next few years due to slowdown of economic growth; second, banking sector may face with liquidity deficiency due to saving decrease. In fact, we have already observed that the growth rate of household deposit has declined since 2008.
However, as an old Chinese saying goes: 天无绝人之路 (every cloud has a silver lining). There’re at least three opportunities for Chinese economy. The first is the room for labor transition, although the demographic turning point is coming. In 2010, the China’s non-agriculture employment is only 45 percent of total population, while in Germany, Japan and United States where aging problem is more serious than China, more than 60 percent of total population are employed in non-agriculture industry. Therefore, if China can maintain the labor transition speed in past decades, it still needs 8 to 12 years for China to reach other developed countries’ level.
The second opportunity is the room for investment. As we have estimated last year, investment per capita of China is only 50 percent of U.S. and capital stock per capita of China even much lower. So the capital deepening- investment- is still a driver for Chinese economy. Fortunately, investment is more efficient in China than other countries. In the first decade of this century, the incremental capital-output ratio- the increase of capital-output ratio to support 1 percent of growth rate (the lower, the better)- is 4 in China, 4.2 in India, 4.8 in Brazil, 11 in U.S., 20 in Germany and 33 in Japan.
The third opportunity is reform. Although the demographic dividend may disappear, the reform dividend still has its momentum. Policy makers and most Chinese economists believe the further reforms, such as reform of monopolized industry and SOE, fiscal system reform and financial reform, will enhance economic performance dramatically. For instance, we know that financial reform will allow us to use decreasing saving more efficiently and manage increasing risk better. We know that, among financial reform measures, deregulation is the key. But why there’s almost nothing happened in the past decade? It’s mainly because deregulation requires regulatory entities, such as CSRC, to relinquish administrative power. There’s too much vested interest in it.
In short, the turning points are coming. But China will be able to maintain 7 to 8 percent GDP growth rate for at least 8 years. Whatever the difficulty is, the 2020 will witness the turning point of hundreds years- the great China Age.
