The “chinese economic miracle”. Separating fact from myth

China’s remarkable economic growth has structurally decelerated since 2010. This paper presents a baseline scenario in which China’s growth is projected to reach 2.4 % by 2035, while examining various downside risks, ranging from population aging to the rapid reduction of returns on assets, and the fast accumulation of debt. Although innovation presents the potential for upward growth, its positive impact on total factor productivity has yet to be witnessed. Overall, the risks to China’s long-term growth generally lean towards the downside.

Introduction

Since a series of reforms took place in the late 1970s, China has recorded remarkable growth for decades. From 1978 to 2010, the average growth has hovered around 10 %, placing China in the 1 % percentile for countries moving from 1,000 to 10,000 usd per capita. This, together with the over 800 million people that China has lifted out of poverty, clearly justify the expression of the “Chinese economic miracle”. As of today, China continues to serve as the most important engine for global growth, contributing about one third of the total global growth over the last three decades.

With ‘reform and opening up’ as the key mantra since the late 1970s to transform China from a planned to a market economy, the country has been increasingly intertwined with the rest of the global economy through trade and investment and a growing participation in the global value chain. This is attributed to China’s obvious economies of scale, relatively low wages, and logistical infrastructure, supporting manufacturing. China’s accession to the wto in 2001, and the support of Western companies investing there, coupled with massive technology transfer, are also important external factors behind China’s success.

However, China’s growth trajectory reached its peak in 2010 and has been slowing down since then, especially since 2015. Although China’s growth rate remains higher than global average and even higher than other emerging markets, at least on average, China’s era of very high growth is over.

In particular, both the trade war led by Trump since 2018, and more significantly, the Covid pandemic since 2020, have resulted in rapid deceleration of China’s growth, all the way to barely 3 % in 2022. Entering 2023, while a cyclical boost is expected due to the full removal of pandemic-related mobility restrictions, growth will remain subdued compared to pre-pandemic levels, although it should still meet the very conservative target set by the Chinese government last March, which was 5 %.

The reasons for such a sobering growth outlook are mostly structural and will be reviewed in this article after some more details on the miracle years. Ultimately, our medium-term growth outlook points to China’s growth decelerating to 2.3 % by 2035. There are several downward risks and a positive wild card, namely that of innovation, considerably impacting growth on the positive side.

A review of China’s growth miracle

China’s rapid growth since 1978 has received wide attention and interest from scholars and policymakers around the world. As shown in Figures 1 and 2, when we compare economies’ 10-year average gdp per capita growth rates after they reach per capita incomes of $1,000 and $5,000 after 1961, the ninetieth percentile of the distribution of annualized growth rates are 7.1 % and 4.4 %. China has achieved even higher growth rates of 9.9 % and 6.3 %, respectively, after reaching the $1,000 and $5,000 thresholds, indicating sustained higher growth compared to many other countries after surpassing certain levels.

Figure 1. Real gdp per capita growth rate in the next 10 years (post $1,000 gdp per capita)

Fuente: Natixis, Banco Mundial.

Note: Average real gdp per capita growth rate for the 10 years after an economy reaches $1000 per capita (ranked by percentile, based on world gdp from 1960 to 2020).

Figure 2. Real gdp per capita growth rate in the next 10 years (post $5,000 gdp per capita)

Source: Natixis, World Bank

Note: Average real gdp per capita growth rate for the 10 years after an economy reaches $5000 per capita (ranked by percentile, based on world gdp from 1960 to 2020).

China’s economic success can be explained by some drivers. Before the reform and opening up introduced by Deng Xiaoping, China was still a planned economy. The first reforms began in the agriculture sector, with increased incentives for rural households to boost agricultural output. Then reforms spread to the urban industrial sector, including introducing the dual-price system which greatly reduced shortages of supply, and allowing private businesses to operate, spurring competition and flexibility.

At the same time, China opened its door to embrace foreign investment, mostly in special economic zones in coastal areas of China, including Shenzhen, Guangzhou, Xiamen and Zhuhai. These zones became engines of growth for China’s economy. Foreign businesses flocked into China. As the figure below shows, foreign direct investment (fdi) inflows into China rose substantially during the period between 2000 and 2014.

Figure 3. Foreign direct investment, net inflows (BoP, usd)

Fuente: Natixis, World Bank.

Foreign investment played an important role in bolstering China’s economic growth, not so much because of the funding (China has generally had high savings), but mostly due to the technology transfer that it brought along, as well as the management skills. At that time, China had a vast young, inexpensive workforce, but it lacked managerial capabilities, technology, and know-how. Foreign direct investment, thus, was particularly important in the manufacturing sector. The surging foreign direct investment (fdi) not only brought higher quality jobs and wages, but also technology, enhancing competition in the domestic market.

Furthermore, productivity gains also played out in China’s booming economy. These gains not only came from technology improvement and its spillover effect, but also from factor reallocation. The latter was best symbolized by two trends, urbanization, and the structural reform of state-owned enterprises (soes) that started in the 1990s. Both processes contributed to factor reallocation by migrating a large portion of China’s workforce from the agricultural sector to the urban industrial sector, and from the less efficient public sector to the more vigorous private sector.

Beyond the reform and unilateral opening-up efforts to attract fdi, China’s accession to the wto in 2001 marked a new chapter. With access to the global markets, China’s advantages in producing cheap products and mass manufacturing capacity finally had a pathway to reach consumers around the world. Alongside fast urbanization, China found a new tool to boost growth: exports. However, these exports, still required state-led investment to improve the logistical infrastructure needed to become more competitive.

During this process, despite experiencing very rapid growth, China continued to control wage growth and maintained a stable renminbi until 2005, with a relatively slow appreciation thereafter. Both suppressed wages and a cheap exchange rate clearly helped China increase its global market share of exports.

China’s long-term prospect: A baseline scenario

After years of rocket growth followed by a significant slowdown, assessing China’s future growth rate will provide important implications not only for China but also for other developing economies. In this section, a baseline scenario for China’s long-term growth is introduced based on the Solow’s convergence theory. This theory is based on the assumption that in the long run, countries’ growth rates will converge, meaning that poorer countries will grow faster than richer countries along this convergence path (Solow, 1956).

Many studies have adopted this framework and pointed to a slowing growth path for any country having reached middle income growth of around 10,000 usd per capita. For example, the World Bank (2019) expected China’s average annual growth rate to decline to 4 % from 2021 to 2030 in a scenario of limited reforms, which aligns with today’s situation. On a slightly more positive note, Albert et al (2015) suggested that China would continue on its deceleration path over the next decade, but would still maintain a growth rate above 4 percent in 2030. It’s worth noting when their calculations were done.

A convergence growth theory points to China’s average growth rate standing at 4.9 percent from 2021 to 2025, and at 3.6 percent from 2026 to 2030 (Table 1 and technical details in the appendix).

Table 1. Forecasting China’s potential gdp growth rate (%) based on the convergence model

That said, China will still be able to avoid the middle-income trap as its growth remains relatively high compared to other countries. As shown in Figure 4, the average growth rates in the next 10 years after crossing the 10,000 usd per capita threshold were only 3.8 %. China’s expected growth, even if it ends up growing barely 2.4 % in 2035, will still stand at 4 % in the 10 years after reaching the threshold, surpassing the world average. Figure 5 shows that China will only perform behind South Korea, higher than Japan and outperforming many economies that have overcome the middle-income trap (Figure 5).

Figure 4. The real gdp per capita growth rate (%) in the next 10 years when an economy’s gdp per capital past 10,000 usd (by percentile, based on the world’s gdp from 1960 to 2020)

Fuente: Natixis, World Bank.

Figure 5. 10-Year Average Growth Rate (%) After a economy crossing the 10,000 usd per capita threshold

Source: Natixis, Author’s calculation.

Upside and downside risk to the baseline growth scenario

The first downward risk comes from population aging, as discussed previously. China had long been the world’s most populous country, only recently surpassed by India. Its working age population was growing fast from 1970 to 2010, which provided a vast pool of workers for businesses to choose from (Figure 6). This sustained growth has kept China’s labor costs low for an extended period and helped it remain competitive globally. All in all, the ‘population dividend’ was certainly one of the supporting factors for Chinese growth in the past decades. Such favorable demographics were also accompanied by China’s urbanization process, which migrated people from the low-productivity agricultural sector to the higher-productivity sector in the cities.

However, China’s fertility rate has been declining and reached a record low of 1.09 in 2022. The United Nations has forecasted a population contraction starting from 2025. As a result, China’s fertility rate is now among the worst worldwide, alongside well-known aging countries such as South Korea and Singapore.

Figure 6. China: Population (bn)

Source: Natixis, United Nations. Projections after 2022.

While the picture appears worrying, what is interesting, though, is our finding that aging will hardly be a factor in explaining growth deceleration up to 2035, thanks to the remaining scope for urbanization in China. But from 2035 onwards, aging will pose an important challenge to China’s growth. By then, the urbanization process should have been completed, and the sharp drops in the birth rate that began in 2017 will start to have a noticeable impact. More specifically, one can expect an additional one-percentage-point reduction in China’s annual growth rate from 2035 onwards (Figure 8). This will make China look very much like Japan today, growth wise.

Figure 7. China: Share of different age group (%)

Source: Natixis, United Nations.

Figure 8. Forecast impact of population aging on China’s gdp growth rate ( %)

Source: Natixis.

A second very relevant downward risk lies on China’s diminishing return on investment. Capital accumulation was also a key element in China’s growth story. Its growth mode has even been described as investment-led, given the crucial role that investment has played in contributing to gdp growth during the past few decades (Figure 9). However, the fact that China’s investment-to-gdp ratio is one of the highest in the world, reaching 43 % in 2021, clearly indicates there is limited room for further growth and also explains the decreasing returns on scale.

Figure 9. Gross capital formation contribution to gdp growth ( %)

Source: Natixis, National Bureau of Statistics, ceic.

Years of massive investment have clearly pointed to an overinvestment problem.  More specifically, from 2017 to 2022, return on assets has continued to decline for state-owned enterprises (soes), but even sharper declines have been observed for privately-owned enterprises (poes), although the return on assets remains higher for private companies (Figure 10).

Figure 10. Chinese Corporates: Average roa ( %)

N.B. Calculations are based on bond-issuing companies using wind’s bde and bsc functions. The average return on assets is defined as the simple average of the ratio of gross return over total assets for all sampled soes and poes (excluding financial companies and local government financing vehicles)

Source: Natixis, Wind

A third risk is the fast-growing public debt, especially since the pandemic. Aside from the increase in pandemic-related public pandemic spending, the government’s pressure was compounded by China’s ailing housing market, as local governments relied heavily on land sales for funding. With a crisis-ridden real estate sector, which witnessed multiple defaults by developers and the challenges faced by property giants such as Evergrande and Country Garden, local governments have been tackling growing difficulties.

However, what makes China’s public debt more worrisome is the off-balance part. In recent years, local governments have extensively used the off-balance sheet platforms, i.e., local government financial vehicles (lgfvs), to finance infrastructure and real estate projects. This part of the public debt, though closely linked to the government, has yet received full government recognition, which adds to the complication of fully gauging the level of public debt, let alone its impact on growth. All in all, as of Q1 2023, China’s lgfv debt has reached 46 % of gdp. Together with on-balance sheet debt, China’s public debt now accounts for nearly its gross domestic output (97 %).

It is important to note that the accumulation of public debt does not necessarily harm potential growth, as it depends on how the money is spent. Given that lgfvs finance most of the investment carried out by local government, one could imagine that their return on assets should be higher than that of other public debt. However, the average return of lgfv projects has declined to a very low level and continues decreasing, especially in the context of China’s average interest rates over the last few years. The average rate of return on assets of the lgfvs was 1.8 percent in 2017 but had dropped to 1.3 percent by 2022 (Figure 11).

Figure 11. China: lgfv Average roa ( %)

N.B. Calculations are based bond-issuing lgfvs (Wind Classification) using Wind’s BDE and bsc functions. The average return on assets is defined as the simple average of the ratio of gross return over total assets for all the sampled local government financing vehicles.

Source: Natixis, Wind.

A fourth crucial risk is coming from China’s external environment, which has worsened dramatically in recent years. The Trump administration drastically changed the direction of us-China relations, transitioning from engagement to competition and rivalry. This trinity has been replicated by the eu commission as well. The competition started with trade through Trump’s substantial import tariffs and moved further to tech containment, which has been pushed even further by President Biden. Technological containment goes beyond export controls to the screening of Chinese investment into the us, and more recently the eu. The most relevant piece of containment likely stems from coordinated export controls on high-end semiconductors and their components (us-Japan-Netherlands) back in May 2023. The extent to which such controls will delay China’s convergence in mastering top technologies, such as semiconductors, artificial intelligence, and quantum computing, remains uncertain.

A fifth, and last, relevant risk is the reshuffling of value chains away from China. Over the years, China’s market share in total exports has been continuously rising. The figure below illustrates the contrast in China’s growing status as a global supplier with the declining share seen in the us, Germany, and Japan from 1978 to 2019 (Figure 12). In other words, at an astonishing rate, China has successfully become an integral part of international trade, and the world has become increasingly dependent on China, especially since China’s reform and opening in 1978 and with a renewed momentum since the Covid pandemic.

Figure 12. China’s trade as a share of global market since 1978 (usd bn)

Source: Unctad, Natixis.

As of today, China is at the center of the global value chain, especially in terms of intermediate goods. In 2003, China accounted for 8 % of global manufacturing exports, but by 2018, this figure had grown to a staggering 19 %. Moreover, China’s dominance in sectors ranging from office machines, furniture, and apparel parts is even higher at 50 %, 60 %, and 40 % of the global market share, respectively. This dominance becomes even more pronounced when focusing on green technology for the decarbonization of the world, especially in areas like solar panels.

However, after the supply shortages during pandemic lockdowns, countries in the world have become increasingly cautious about highly concentrated supply chains and are reassessing their excessive reliance on China. Many of them implemented de-risking measures, respectively, to diversify their sources of supply. Elevated geopolitical tensions further pushed them to secure the supply chains.  As this trend persists, China will continue to face pressure from manufacturers relocating their factories away from China.

In the context of supply shortages during pandemic lockdowns, and with European countries losing their gas supplies from Russia since the invasion of Ukraine, both the eu and the US are reassessing their economic dependencies. Significant future technologies, including permanent magnets used in wind turbines and electric-vehicle batteries, rely on raw materials sourced from and processed predominantly in China. Geopolitical risks related to this were demonstrated in 2010 when China imposed an export ban on several raw materials used in hybrid cars, wind turbines and guided missiles, as part of a maritime dispute with Japan. More recently, the Chinese leadership has also considered similar bans on exports to the us. Excessive dependencies have also been visible in clean technology manufacturing, in which China dominates wind, ev batteries and solar panels. All in all, such reshuffling of the value chain away from China could exert additional downward pressure on growth in the future, especially given how much China has benefited from inward fdi for so many years.

Finally, moving to the potential positive shocks, which could push growth upwards, the most obvious is innovation. Our baseline projection of China’s medium-term growth relies on a linear projection of productivity convergence based on past global experience. However, modern growth theory argues that productivity growth is endogenous, and depends on the endowment of human capital and research efforts to push up total factor productivity (tfp). tfp has long been a key driver of China’s growth (Figure 13), but its growth rate has dropped significantly since the global financial crisis, even more so than global productivity. Whether China’s innovation efforts are providing enough tailwind to mitigate the structural deceleration of the economy will be a crucial question for the medium-term future.

Figure 13. Growth in Total Factor Productivity ( %)

Source: The Conference Board, Bruegel.

China’s leadership knows this and has made innovation policy its top priority. Under different slogans such as ‘Made in China 2025’ or the party’s ‘Innovation-driven development’, reaching and expanding the technology frontier in major industries has become the goal of economic policy. In an overview of China’s progress on innovation and its impact on growth, García-Herrero and Schindowski (2023) find that China’s performance in terms of increasing inputs to innovation, R&D and educational attainment, is clearly favorable, and so are the intermediate outcomes, such as the number of patents and scientific publications (Figures 14 and 15). However, these intermediate objectives, including the increasing value added of exports in China, have not translated into a corresponding increase in total factor productivity and, consequently, growth.

Figure 14. uspto total patent grants (pct and direct), by country

Source: wipo Statistics Database.

Figure 15. Number of articles published in scientific and technical journals, by country

Source: World Bank, National Science Foundation.

In summary, the risks are tilted towards the downside as far as China’s growth is concerned. Nevertheless, it is too early to assess how much innovation may eventually contribute to growth by increasing total factor productivity.

Conclusions

China’s so-called growth miracle is indeed one of the most impressive cases of a successful development case reaching the level of middle-income countries. However, China’s growth peaked in 2010 and has continued to decline since, structurally. There are a number of downward risks beyond such structural deceleration, from aging, to the increasingly low return of assets and the massive accumulation of public debt. The final risk stems from the reshuffling of the value chain, which is behind the reduction in fdi into China.

As for the upward shocks, innovation is the most obvious as it can increase total factor productivity, but this is not what we have seen so far. In fact, total factor productivity is actually decelerating in China. All in all, while one can talk about China’s economic miracle, the future looks very different from such past reality.

References

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