When Xi Jinping, General Secretary of the Communist Party of China, visited Henan Province in May 2014, he said, "Our country is still in a period of important strategic opportunities, and we must boost our confidence, adapt to the new normal condition based on the characteristics of China's economic growth in the current phase, and stay cool-minded." Following this statement, the phrase "new normal" began to appear frequently in the media as keywords when discussing the Chinese economy (Note 1). In light of these discussions, I will consider (1) the features of the new normal and (2) economic policies under the new normal.
Features of the new normal
The shift to the new normal in China occurred at around the same time as the global financial crisis prompted by the collapse of Lehman Brothers, but the real trigger appears to be the falling potential growth rate associated with a shortage of labor. The Chinese economy that has entered this new normal has four features different from those during the high-growth period it enjoyed during the preceding 30 years.
1) Slower economic growth
The real gross domestic product (GDP) growth rate in China, which has averaged 9.8% annually since shifting to economic reform and opening up and 8.7% since the Lehman Brothers collapse, decelerated to 7.4% in the first half of 2014, after falling below 8% in 2012 and 2013 (Figure 1). This is due largely to a decline in the potential growth rate resulting from structural factors such as the labor shortage, rather than a cyclical contraction in demand. It is no longer likely that China will return to the high growth experienced in the past, and maintaining a moderate high growth of 7% to 8% in the years ahead will be a challenge.
Driven by the trends of such demand components of GDP as consumption, investment, and exports, the economic growth rate in the short-run tends to fluctuate around the potential growth rate, which is determined by supply-side factors. If the potential growth rate declines, the actual economic growth rate will also follow suit.
The potential growth rate refers to an economic growth rate that will be achieved if various resources are allocated optimally and fully utilized in a given period in a country (region). In China, the potential growth rate appears to have fallen significantly in recent years against the backdrop of a decline in the working-age population and the arrival of the Lewisian turning point, which refers to the elimination of surplus labor in rural areas.
Conceptually, the growth rate comprises contributions of expanding labor input and rising labor productivity, and the latter can be divided further into expanding capital input and rising total factor productivity (TFP). The average growth rate in China from 1995 to 2011 (which is considered to be the potential growth rate during that period) reached 9.9%, which can be broken down into the contributions of the expanding labor input (estimated at 0.7%), the expanding capital input (5.3%), and the rising TFP (3.7%,) (Figure 2). As the two changes in the labor market mentioned above work to hold down the growth rates of labor input and capital input, the potential growth rate should decline if the growth rate of TFP stays unchanged.
- 1) Contribution of total factor productivity growth includes contribution from human capital growth.
- 2) Components do not add up to 9.9% due to rounding.
First, the declining working-age population means that the population dividend is turning into an onus. Until recently, the working-age population had been increasing, while the savings rate had been high thanks to the relatively young population structure. The rise in the working-age population had resulted in an increase in the labor supply, while the high savings rate had led to the expansion of capital input as domestic savings are the major source of funding for investment. However, with the working-age population starting to decline and the aging of the population gathering pace, the growth rate has come to be constrained by a decline in the labor supply and a falling savings rate.
The arrival of the Lewisian turning point also has put a drag on growth. Until recently, the availability of abundant, if not infinite, supply of labor had been supporting China's economic growth through the following routes. First, the absorption of surplus labor in the agricultural sector by the industrial and service sectors had contributed directly to the expansion of GDP. At the same time, the shift of labor from the agricultural sector with low productivity to the industrial and service sectors with high productivity also had boosted the productivity of the overall economy. In addition, low wages maintained by surplus labor had worked to the advantage of the high-income group with high capital income, which in turn had led to high savings and high investment. However, achieving full employment implies slower growth in the supply of labor in the industrial and service sectors, and with the savings rate also falling, the potential growth rate should decline.
In addition to the labor shortage, the fact that problems related to resources and the environment have become serious and that the latecomer advantage is fading along with the narrowing gap with developed nations have contributed to lowering the potential growth rate.
2) Improved economic structure
Amid the declining potential growth rate, China has come to give weight to qualitative improvement, rather than quantitative expansion of the economy, and the country's economic structure has improved in terms of industrial and demand composition as well as income distribution.
First, regarding industry, as problems related to resources and the environment have become serious, the limitation of economic development based on the massive consumption of resources and, at the sacrifice of the environment, has become obvious. Instead, the service (tertiary) industry, which consumes less resources and is more environmentally-friendly, is attracting attention as a new growth area. In fact, as economic development progresses in China in line with Petty-Clark's law, the primary and secondary industries' share of GDP have declined, while the tertiary industry's share has risen to exceed that of the secondary industry for the first time in 2013 (Figure 3).
In terms of demand, the export competitiveness of Chinese products has fallen due to rising wages and resource prices, and the capacity to invest has also declined against the backdrop of the falling savings rate. On the other hand, the higher income level of people and the development of social security have contributed to the expansion of consumption. In fact, private consumption is becoming a driving force of economic development in place of investment and exports, with its share of GDP turning into an upward trend from the bottom in 2010.
Regarding income distribution, rising wages associated with the labor shortage has contributed to a reduction in the income gap through raising labor's share of GDP. Also, thanks to the shift of some industries in the coastal region, which is facing a shortage of land and labor, to the inland region, the latter has come to grow faster than the former, reversing the traditional pattern. In addition, massive migration of rural population to the urban areas associated with accelerated urbanization has narrowed the income gap between the rural areas and the urban areas through remittances to families and other channels. In fact, the gaps between the coastal and the inland regions, between the urban areas and the rural areas, and between the high-income group and the low-income group have narrowed one after the other. As a result, the Gini coefficient, which shows the income gap of the country as a whole, has declined from its peak of 0.491 in 2008 to 0.473 in 2013 (National Bureau of Statistics of China).
3) Increasing importance of innovation
Until now, the low costs of production have driven China as the workshop of the world, but the rise in the prices of factors of production has prompted the country to shift the driving force of economic development from the expansion of inputs such as labor and capital to the improvement of productivity through innovation. Many Chinese companies have gone beyond introducing technologies from overseas and come to engage in research and development actively on their own with the aim of accelerating innovation. As symbolized by the rapid growth of high-tech companies such as the Alibaba Group, an e-commerce company, and Huawei Technologies, a telecommunications equipment company, innovation is becoming a driving force of not only economic development, but also advancing industries in China.
4) Rising financial risk
The decelerating economic growth is exposing risks that lurked during the high economic growth period. In some conventional manufacturing industries, many companies are suffering overcapacity and have fallen into business difficulties. Also, following the tightening of regulations on shadow banking by the authorities, many companies have come to face funding problems and rising financing costs. In addition, with the real estate market entering a correction phase, local governments, which rely heavily on "land finance," have found their revenues falling, and their debt-paying ability has come to be questioned. In this environment, it is still uncertain whether the Chinese economy will be able to achieve soft landing without triggering a financial crisis (Note 2).
Economic policies under the new normal
Under the new normal in which the potential economic growth rate has fallen significantly while the risk of economic crisis has yet to be swept away, the Chinese government is carrying forward an economic policy (so-called Likonomics) consisting of three pillars, namely, the maintenance of stable growth, structural adjustment, and promotion of reforms. Among them, the promotion of reforms is positioned as the top priority.
1) Maintenance of stable growth
Premier Li Keqiang points out that the main purpose of macro control is to avoid large fluctuations in the economy by maintaining the economic growth rate above a certain level and the inflation rate below a certain level. Although no specific numbers have been indicated, a target growth rate of 7.5% and an inflation rate of 3.5%, which were announced at the National People's Congress in March 2014, may serve as useful references.
If China strains to pursue high economic growth as in the past with expansionary fiscal and monetary policies, ignoring the falling potential growth rate, it will have to pay a high price for the following reasons. First, although the growth rate will rise temporarily due to stimulus measures, growth will slow down once again with the elapse of time, and new stimulus measures will be required. In this manner, the economy will have gotten addicted to stimulus measures. Second, as in the case of the four trillion yuan package implemented to stimulate domestic demand following the Lehman Brothers collapse, it will be mainly state-owned enterprises, rather than private-sector companies, that will reap the benefits. The corresponding phenomenon of "advance of the state and retreat of the private sector" (the increasing share by state-owned enterprises and the decreasing share by private-sector companies) runs counter to the market reform China aims for and could devitalize the economy. Third, stimulus measures will result in excessive production capacity and leave companies with a high debt burden, as what actually happened as an aftermath of the previous episode of fiscal stimulation. Lastly, stimulus measures will foster the expansion of the real estate bubble. In fact, the steep rise in real estate prices mainly in housing in recent years has a lot to do with the significant monetary easing implemented after the Lehman Brothers collapse. If the real estate bubble collapses, bad debt in banks will increase, and the macro economy could suffer as Japan did during the 1990s.
Therefore, the top priority for China is to raise the efficiency of the use of funds through financial and fiscal reforms and prevent an economic crisis from occurring rather than launching stimulus measures to maintain high economic growth. Above all, there is an urgent need to keep under control loans through the shadow banking system, the expansion of local government debt, and rising housing prices.
2) Structural adjustment
China needs to change its pattern of economic development by shifting the growth engine from the manufacturing sector to the service sector in terms of industry, from investment to consumption in terms of demand, and from the expansion of the input of factors of production such as labor and capital to the raising of productivity through improving the innovation capacity of companies and advancing industry in terms of the mode of production. For that purpose, the following measures have been taken ("Some Issues Concerning the Deepening of the Economic System Reform" Qiush Journal, ninth issue of 2014, Li Keqiang, May 2014).
First, in terms of industry, China has been promoting the development of the service sector with policies of reform and opened it up as a driving force. For that goal, China is switching the business tax currently applied to services to a value-added tax, as has already been applied to goods in order to reduce the tax burden on service companies. On top of that, China is promoting the orderly opening to the world of service areas such as finance, education, culture, sports, medical services, and care for the elderly and has eased the restriction on the entry of foreign capital.
In terms of demand, China has made efforts to improve the functioning of the domestic distribution market through institutional reforms, in addition to working on reforming the income distribution system, enhancing the social security system, developing new consumption areas, promoting service consumption, and developing new business categories such as online shopping to increase consumption.
With respect to improving innovation capacity and advancing industry, China has been promoting the entry of companies at the high end of the global value chain. China also is sticking to the principle of the survival of the fittest in market competition, and encouraging the merger and realignment of companies, strengthening standards for environmental conservation, safety, energy consumption and land use, putting various preferential treatment policies in order, promoting the reduction of old equipment and excessive production capacity, and strictly regulating new investments. In addition, China is accelerating technological improvements in companies and promoting the advancement of conventional industries. Lastly, China is building an innovation platform, making a trial for regional clusters and pressing forward the development of strategic emerging industries.
Since the spring of 2014, the Chinese government has been launching a series of fiscal and monetary policies called "mini-stimulus measures," targeting certain sectors. Specifically, on April 2, 2014, the State Council announced favorable tax treatment for accelerating railway investments and small companies. On the monetary policy front, the People's Bank of China reduced reserve requirements twice in April and June of 2014 for banks whose loans to small companies and the agricultural sector have reached a certain ratio. Although these policies are usually interpreted as macroeconomic measures, they should be regarded instead as structural reform measures, given that their aim is to harmonize development between regions, narrow the gap between the urban areas and the rural areas, guarantee the stable supply agricultural products, and support small companies.
In addition to such direct measures, promoting urbanization is expected to contribute to shifting the economic development pattern in the medium and long term through expanding domestic demand, advancing the industrial structure, solving the three agriculture-related problems (agriculture, rural villages, and farmers), and narrowing the gaps between regions.
3) Promotion of reforms
Regarding the promotion of reforms, the focus is to revise the division of roles between the government and the market.
Since shifting to reforms and opening up the economy at the end of the 1970s, China has been moving from a planned economy to a market economy. However, with administrative reform lagging behind economic reform, the government still intervenes in areas where it should not (overstretching), while it does not play a proper role in areas where it should (negligence).
One example of overstretching is that the government still controls important resources such as land while key industries are still monopolized by state-owned enterprises. In addition, bureaucrats with authority have plenty of room for discretion and are directly involved in the economic activities of companies. Comparing this to sports, with the government being both a referee and a player, obviously a fair game is out of the question.
On the other hand, an example of negligence is the shortage of public services such as in environmental conservation, social security, medical services, and education. Economic laws are not fully developed either, and the implementation of these laws lacks transparency. In addition, it is also desirable that the infrastructure for credit and the order of transactions will be developed, and that the macro controlling ability of the government will be strengthened.
To solve these problems, it is necessary to revise the role of the government to match the needs of the market economy in the years ahead. On top of that, to capitalize on the vigor of the market and private-sector companies, it is necessary to build an equitable and fair market environment through deregulation and the breaking up of the monopoly of state-owned enterprises in many areas.
The reform policy for that goal was presented in the "Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform" adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China (the "Third Plenum") held in November 2013. Premier Li Keqiang also promised that the government will fully enforce the following: (1) make a "power list" to clarify what it should do, as well as what it is unable to do without being authorized by law, (2) clarify what companies are not allowed to do by making a "negative list" as well as what they are allowed to do if the law does not prohibit it, and (3) clarify how it manages markets by making a "responsibility list" in which it will fulfill responsibilities stipulated by law (Li Keqiang, a speech at the opening ceremony of the 2014 Summer Davos Forum held in Tianjin on September 10, 2014).
For the China that has shifted to the new normal, sticking to these policies will be the key to achieving an improvement in the economic structure by maintaining growth over the medium and long terms and leveraging a new driving force of innovation, while avoiding risks.
The original text in Japanese was posted on October 03, 2014.
