Balancing growth and structural adjustment in China

BEIJING — After a disappointing performance in 2018, China’s economy appears to be stabilising. In the first quarter of 2019, GDP growth, at 6.4 per cent year-on-year, matched that of the previous quarter. But growth in industrial production exceeded expectations, expanding by 6.5 per cent year on year and by 8.5 per cent in March. Even exports growth was positive, albeit weak, despite the ongoing trade war with the United States.

Moreover, fixed-asset investment (FAI) grew by 6.3 per cent, 0.2 percentage points higher than in the previous quarter. Investment in real estate grew the fastest (11.8 per cent), followed by manufacturing (4.6 per cent) and infrastructure (4.4 per cent). Growth in both real estate and infrastructure investment was stronger not only sequentially, but also year on year. As usual, consumption growth was stable. All of this has inspired confidence that the Chinese economy can reach its indicative growth target of 6-6.5 per cent for 2019.

Most Chinese economists seem quite comfortable with this targeted range. One explanation is that China’s potential growth rate is 6-6.5 per cent, and a target should be set accordingly. Another is that a lower growth rate would give the economy more room for structural adjustment.

From 1978 to 2008, China averaged an impressive 9.5 per cent annual growth rate. Then the global financial crisis struck, causing growth to plummet from 9.7 per cent in the third quarter of 2008 to 6.6 per cent in the second quarter of 2009. A CN¥4 trillion ($640 billion) stimulus package, introduced in November 2008, soon brought about a powerful rebound, with GDP growth reaching 12.1 per cent in the first quarter of 2010. But, since then, China’s economy has been on a continuous downward slide, partly because the government withdrew its stimulus. Last year, China’s GDP grew by 6.6 per cent. Nevertheless, it is difficult to separate cyclical elements and external shocks from the long-term trend and to conclude that China’s potential growth rate really is between 6-6.5 per cent.

Many Chinese economists cite long-term supply-side structural factors, such as demographic ageing, environmental degradation and a lack of progress on reform, to argue that China has simply entered a new stage of development, characterised by significantly lower potential growth rates.

This may be true, everyone in China agrees that 9-10 per cent annual growth rates are a thing of the past, but there is no clear indication of how much China’s growth potential has actually declined. Long-term supply-side structural factors do not explain, for example, why the growth rate fell from 12.1 per cent in the first quarter of 2010 to 7.4 per cent in the third quarter of 2013.

Not only are there missing links on the causality chain between long-term structural factors and actual economic performance; it is unclear how long those factors would take to constrain GDP growth to a particular level. In fact, 20 years ago, the same long-term factors were used to warn of a possible fall in Chinese GDP growth.

Because of the complexity of China’s growth trajectory, many economists seem to base their assessments of potential on performance. After every drop in China’s GDP growth since the second quarter of 2012, when growth fell below 8 per cent, economists have emerged to declare that performance was in line with potential.

To be sure, there are various estimates of China’s potential growth rate, ranging from 5 per cent to 8 per cent. But it is difficult to determine which is reliable. For one thing, there is reason to believe that most estimates fail to discount cyclical factors adequately when calculating the long-term trend.

The danger here lies in the fact that excessively low growth targets, based on excessively low estimates of potential growth, lead to lower actual growth. For an economy the size of China’s, a difference of even 1 percentage point has a huge impact on welfare.

Many economists would counter that a conservative growth target is useful, or even necessary, to create space for structural adjustment. But this claim is unconvincing. Reducing China’s excessive reliance on real-estate investment, one of the economy’s most serious structural problems, does not necessarily require a reduction in FAI growth, let alone GDP growth. Nor is slower GDP growth a prerequisite for improving financial stability.

In my view, because no one is sure what exactly China’s potential growth rate is, the best strategy is to try to achieve as high a growth rate as possible, so long as it does not worsen inflation and hinder structural adjustment.

True, the first quarter of 2019 yielded better-than-expected results. But the higher rate of FAI growth was to a large extent driven by a strong increase in real-estate investment, which is likely to weaken sooner or later, owing to the government’s commitment to cooling China’s “real-estate fever”. And, given enduring trade tensions with the US, China’s export performance for the rest of 2019 is highly uncertain.

To compensate for declining real-estate investment and weakening exports, China must maintain reasonable growth in infrastructure investment. To that end, the government should pursue higher spending, taking advantage of a strong fiscal position, supported by accommodative monetary policy, amid very low inflation.

Fiscal and monetary expansion may be out of fashion among China’s mainstream economists, who insist that structural adjustment must be the priority. But it could go a long way toward bolstering China’s economic performance in 2019, without impeding structural reform. The challenge is to strike the right balance.

Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006. Copyright: Project Syndicate, 2019. www.project-syndicate.org