Written by Erik Tollefson.

As the size of China’s economic growth has gradually slowed, narratives prophesying its downfall have proliferated. Indeed, heated disagreement has emerged about whether slower economic growth “post-miracle” is part and parcel of the development process, a failure to switch economic models, or a harbinger of something more ominous, namely a protracted hard landing. Overall, the slowing of the Chinese economy is not synonymous with the end of the economic miracle. However, the government’s ability to adopt a more sustainable growth model coupled with the pace of deceleration, will determine how the necessary economic transition is perceived.

The term “economic miracle” is not exclusive to the case of China; indeed, in the twentieth century alone miracle was a common description for a vast array of impressive economic performances from Chile to Germany and Italy. The term was also used to describe the development trajectory of Asian economies, including Japan and the four Asian Tigers, Hong Kong, Singapore, South Korea and Taiwan, during the second half of the twentieth century.

At least three factors comprise the archetypical definition of an economic miracle, particularly in Asian contexts. First, this group of countries achieved economic prosperity from a low economic base. Japan and South Korea began their meteoric economic ascent after highly destructive wars. Second, these countries posted high growth rates, primarily on the back of state-led manufacturing and export policies. Although the specific development models differed from country-to-country, all countries leveraged high investment levels and exports as the main growth drivers. Finally, these countries sustained high rates of economic growth over a period of time: some registered above-trend growth rates for more than a decade.

China’s economic development fits these conditions. The Chinese economy on the cusp of reform in 1978 was dilapidated due to the ravages of the Cultural Revolution. In response, the Chinese government developed a state-led playbook stressing export development to leverage low labour costs and concentrated investment in manufacturing to become the “world’s factory.” The proof of the miracle is in the numbers: According to IMF data, the Chinese economy averaged double-digit annual economic growth from 1980-2000. To put this record in context, scholars Lant Pritchett and Larry Summers find that China’s posting of economic growth above 6% for a total of 32 years may be the only example in the history of mankind; the median global duration is 9 years.

Just as other fast-growing economies before, however, China’s rate of growth has decelerated to a still respectable 7.7% in 2013. Some economists forecast that growth rates will fall further to 4% as early as a couple years from now; others posit a more drastic reduction due to government efforts to stimulate growth with monetary policy after the financial crisis in 2008.

Thus, two questions emerge: 1) Is an economic slowdown inevitable? 2) If so, what are the potential explanations or future scenarios?

In answer to the first question, Lant Pritchett and Larry Summers[1] argue that, with apologies to sell-side investment personnel, past performance is not a guarantee of future returns for forecasting economic growth. That is, economies that historically post high growth rates tend to slow down and ultimately revert to the global mean economic growth rate. The paper does not take an explicit view on why this slowdown occurs (although some hypotheses are ventured); however, the authors see it as an inevitable empirical reality rather than a government policy failure.

In answer to the second question, although numerous possibilities exist, three will be briefly explored here: 1) best case: transition to a new economic model; 2) muddle through: descent into the “middle-income trap” 3) worst case: a hard landing.

Although China’s reliance on the investment centric, export-based model served a valuable role in its economic development, a transition to a more sustainable economic model is needed.  Indeed, gross capital formation, one proxy for domestic investment, has remained relatively high through China’s development at close to 50% of GDP; studies have also shown that return on capital has fallen over the same time period. At the same time, the global financial crisis has dented export growth calling into question the model’s long-term viability in an era of stagnant demand. The best case scenario would involve the Chinese government moving towards a more balanced economic model, with higher levels of consumption. This would be a gradual transition, and still involve a deceleration of growth; however it would preserve current gains and could also improve living standards through increased spending on public goods.

The other scenarios would involve slower economic growth, stagnant living standards, and potentially worse. The idea of the middle income trap was popularized in 1970s after numerous South American countries registered fast growth rates but quickly stagnated and failed to reach developed status. According to the IMF, there are myriad reasons why countries fall into the trap including lagging productivity and potentially connected structural factors such as a country’s quality of institutions, overall education level, and an unfavorable demographic profile. While there is still a lack of evidence that China has or will fall into the middle income trap, if it were to happen, growth rates for the economy and per-capita income would fall making any economic transition more difficult to achieve.

The final and worst case scenario is the “hard-landing” of the Chinese economy. In this scenario, the toxic cocktail of rampant credit expansion to boost growth after the 2008 financial crisis, coupled with increased government corruption and misallocation of capital, sowed the seeds for a sharp and prolonged economic downturn. In this analysis, not only did government policy enable the crash, measures to ensure continuation of the miracle caused a “hard landing.”

Overall, China’s economic growth rate will decelerate from the halcyon days of the 1980s and 1990s. Whether this economic transition to lower growth is perceived to be the end of an economic golden period, or merely a different phase of the original growth story, will largely depend on the severity of the deceleration and how the government ultimately responds via reform.

Erik Tollefson is an independent analyst. 

Note

[1] Pritchett, L. & Summers, L.  Asiaphora meets regression to the mean. NBER Working Paper 20573.