17 August 2017
Beijing's central business district. Two Harvard scholars believe China's annual GDP growth rate will inevitably regress to less than 4 percent in the future. Photo: Bloomberg
Beijing's central business district. Two Harvard scholars believe China's annual GDP growth rate will inevitably regress to less than 4 percent in the future. Photo: Bloomberg

Three major hurdles lying ahead for Chinese economy

I have a feeling that Premier Li Keqiang himself may be doubtful about his optimistic outlook for the Chinese economy in this year’s World Economic Forum in Davos. Instead, let’s turn to academic studies based on solid data and objective analysis, which can serve as a more reliable gauge.

In my last commentary, I cited the assertion of Michael Pettis, a professor at the Peking University’s Guanghua School of Management, that a firm’s earnings or a country’s economy built on borrowings with an inverted balance sheet – of which liabilities are inversely correlated with asset values – may advance by leaps and bounds in its heyday, but if the bottom unravels, things will start tumbling down.

Yet overconfident policymakers will typically stick to such strategies even when they are becoming less and less effective.

The ratio of China’s overall credit versus its gross domestic product is an important index. My estimate is that the figure can be well over 300 percent (comparable to that of the United States), although it’s not rare for debt-laden local governments to gloss over their financial standing.

Still, the Chinese central bank continues to shore up loan supply to offset the economic slowdown and the ratio can only climb higher this year. Beijing knows only too well that it must doggedly pursue structural reforms, but since rapid economic expansion is the only way to maintain social stability, it cannot withstand the impact of a lower growth rate.

The stock market presents another example of China’s retrogressive policies.

When Beijing tried to curb rampant speculation through margin trading, the Shanghai bourse immediately suffered a single day loss of up to 8 percent earlier this month. This prompted the security watchdog to loosen the reins, and the amount of new margin loans soon soared by 20 billion yuan (US$3.2 billion).

To have another insight into the Chinese economy and its prospects, I would like to introduce one more research paper: Asiaphoria Meets Regression to the Mean by Larry Summers and Lant Pritchett, two scholars at Harvard’s John F. Kennedy School of Government.

In the paper, Summers and Pritchett notes that the rise of Asia is “a story in at least four parts” – 1) Japan’s ascent to the first world in the 1980s; 2) the boom of four “Asian Tigers” (Hong Kong, Singapore, Taiwan and South Korea) since the 1960s that sent them to the elite club of advanced economies, and the economic advancement of Malaysia, Thailand and Indonesia; and 3) China and India’s revival as major powers. The fourth part is yet to be written.

The significance of the paper is that its findings offer a convincing argument against the overly optimistic notion that the Chinese economy may still be able to expand at a fast pace. Advocates who buy the theory of China’s sustained growth simply project their forecasts based on past data and statistics in a routine, linear correlation. One example is Robert Fogel, professor at the University of Chicago Booth School of Business, who sees China’s GDP exceeding US$123 trillion by 2040 (and notes that even that figure is on the conservative side).

Yet, as the paper points out, past figures cannot serve as a reliable reference, especially in the volatile and constantly changing world of finance and economy.

Examples abound. One is Nobel Prize laureate Paul Samuelson, who predicted in 1961 that the Soviet Union would surpass the US in economic clout in the 1980s, when in fact the union was dissolved at the end of the 1980s.

So what will be a more accurate model to forecast GDP growth? The paper deduces a “regression to the mean” phenomenon. What does mean here refer to? A comprehensive study shows that the mean of the global economy’s growth rate – throughout the periods in which there are data available – is 2 percent with the same standard deviation of 2 percent. China’s high growth rates in the past decades, therefore, have been exceptionally rare.

The paper sums up another common characteristic that can be applied to all economies: developing countries are more likely to experience sharp, frequent acceleration or deceleration in growth rate. In other words, past record is largely irrelevant to future performance, particularly in nations where policies are always formulated and executed in the form of administrative orders.

Not so many economies can bear comparison with China in terms of the continuity of rapid GDP growth. Only Taiwan and South Korea had been on a 30-year winning streak with GDP growth rate of over 6 percent. (Taiwan’s record is 32 years while last year was the 36th year for China.) Yet, after the speed peaked, both Taiwan and South Korea have, inevitably, regressed to a lower annual rate of 3-4 percent.

The paper draws the conclusion that China can hardly be an exception to the “regression to the mean” trend and its future annual rate can only be around 3.98 percent.

There has also been a lot of talk about the “middle income trap”, where an economy, after its people attains a certain income level, will get stuck at that level.

But in a research paper he co-authored, Barry Eichengreen, an economist at the University of California, Berkeley, warns that there are in fact two such traps: one is when a country’s per capita GDP (purchasing power) reaches the level between US$10,000-11,000 and the other is when it reaches US$15,000-16,000. Last year China was already in the danger zone of the first trap.

Given all of these, I believe that the nosedive in China’s growth rate – from the 2007 peak of 14.2 percent to last year’s 7.4 percent – may not have touched the bottom yet. And, judging from the economic fundamentals at this juncture, there are three potential setbacks lying ahead: 1) the first middle income trap, 2) the second trap if China can sail through the first one without a hitch, and 3) the fate of “regression to the mean”.

This article first appeared in the Hong Kong Economic Journal on Jan. 30.

Translation by Frank Chen

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Former full-time member of the Hong Kong Government’s Central Policy Unit, former editor-in-chief of the Hong Kong Economic Journal

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