The working-age population is shrinking, rebalancing needs call for lower investment, geopolitical strife is set to slow productivity-enhancing economic ties with developed economies. These are well-known features that will inevitably decelerate China's trend growth beyond the easing of trend growth due to "convergence" to higher income levels.

Yet China's trend growth continues to benefit from relatively solid productivity growth and capital accumulation. Indeed, S&P Global Ratings' baseline scenario sees China continuing to significantly outpace major developed economies, including the U.S., in the coming decades.

A number of factors could skew the pace of adjustment, creating surprises on the upside or downside. The key factors are the speed of productivity-enhancing reforms and international economic interaction, which is determined by both China's own policy stance and moves to decouple from the country by the U.S. and other advanced countries. We expect continued gradual reform and opening up by China, on its own terms, and material but not drastic decoupling, but our scenarios explore different assumptions on these fronts.

A Trend Derived From Demographics, Rebalancing And Convergence

Our new baseline growth outlook is broadly similar to our 2019 assessment (see "China Credit Spotlight: The Great Game And An Inescapable Slowdown," published on RatingsDirect on June 1, 2019). We still see slower growth as mainly deriving from demographics, rebalancing, convergence and a degree of decoupling by the U.S. and other economies.

We project potential GDP growth to average 4.4% in 2022-2030, and ease to 3.6% by 2030. It will then average 3.1% in 2031-2040, and ease to 2.8% by 2040. The figures through 2030 are broadly similar to those from our earlier analysis.

It may seem surprising that the trend growth outlook hasn't changed materially,given COVID's disruptions to economic growth in recent years. Questions have arisen about economic policy and reform priorities in China, with some worried that economic policy could become less market and reform-oriented. Relations with the U.S. have deteriorated and, more generally, external relations have become more complicated. This will likely increase the efforts to decouple from China's economy by the governments of the U.S. and other advanced economies.

However, in reality, recent developments have largely been as expected in 2019 in terms of key long-term drivers such as productivity-enhancing reforms and international economic interaction. Some decoupling by the U.S. and other advanced economies has been set in train. But in terms of actual external trade and foreign direct investment, international economic interaction has held up (see charts 1 and 2). Meanwhile, the short-term hit of the COVID crisis notwithstanding, its impact on potential output has been modest and the pace of reforms and changes has broadly been as assumed in 2019.

Chart 1

Chart 2

We have adjusted some aspects of the forecast. This includes a smaller reduction in the labor force than in 2019. Based on the latest UN demographic projections, we now expect an average fall in the working age population of 0.2% per year in 2020-2030, a significantly smaller decline than was assumed in 2019. Moreover, we now also expect the decline in the participation ratio to bottom out around 2030 as policy responds to the demographic pressures. Thus labor should, in our revised view, be less of a drag on long-term growth.

Our explicit forecast for investment results in slower capital accumulation in the coming years, compared with the 2019 projections. But it also sees a less-sharp deceleration of capital stock growth later on.

Trend Growth In Recent Decades--Rapid But Slowing

The growth accounting framework economists use to analyze long-term growth trends is very helpful in dissecting how China was able to grow so rapidly in recent decades and why it has seen growth trending down more recently.

The growth-accounting set-up we use is fundamentally the same as the one in the 2019 exercise, but there are a few differences in approach.   We explicitly relate the behavior of the capital stock to investment. Applying one analytical framework for the past and the future, we show how our forecast for long-term trends in labor input, the capital stock and productivity relates to the outcomes in the recent past. We also extend the forecast by 10 years to 2040.

China has seen strong potential output growth in recent decades,   driven by rapid capital accumulation and high total factor productivity (TFP) growth (see table 1). Together, these features have generated impressive gains in labor productivity.

Table 1

But potential output growth has slowed substantially in the past 15 years.

We estimate it declined to 6% in 2016-2021 from 10% in 1994-2007 due to several factors:

Labor input momentum has decreased  because of the demographic transition. Notably, cohorts of young entrants on the labor market have declined.

Capital deepening has decelerated   as the level of the capital stock has risen and the investment to GDP ratio has peaked (see chart 3). High investment levels mean that the capital stock still outpaces output. But the growth differential has diminished, reining in the increase in the capital-output ratio.

TFP growth has slowed   as China's level of development has risen and mileage from leveraging global markets to boost productivity in manufacturing has declined (see chart 4). While hard to measure, the positive impact of productivity-enhancing reforms may also have come down.

At 1.9% per year in 2016-2021, recent TFP growth is lower than the productivity gains realized in South Korea and Taiwan when they were at a similar stages of development. But it still compares favorably to the performance in most other emerging markets. Indeed, unlike some observers (e.g., Summers and Pritchett), we think the experience of China's northeast Asian neighbors is a better benchmark for China than the average emerging market experience.

Chart 3

Chart 4

Looking Ahead--A Further Gradual Decline In Trend Growth

China is facing threats to its economic future. These threats primarily encompass a shrinking workforce, mishandled rebalancing, and slowing productivity gains. To further complicate the productivity picture, the governments of the U.S. and some other developed countries have become increasingly forceful in trying to decouple their economy at least partly from China's. We nonetheless think international economic engagement will continue, if more cautiously than before.

China has some room to maneuver around its labor-force challenge

As labor is becoming scarcer, the government will try to raise the participation rate   (the ratio between the labor force and the population of working age). As a case in point, President Xi Jinping's report presented to the 20th Congress of China's Communist Party (CPC) in October of this year repeated the call for a rise in the retirement age.

The experience of Japan and South Korea is useful as a benchmark.   Both are more advanced in the demographic transition. As labor became scarcer, they have seen their participation rates rise significantly in the last decade. In Japan, where the Abe administration emphasized raising the participation of women and older people as part of Abenomics, the participation rate increased by 6.4 percentage points in the 10 years to 2021 (to 71%) (see chart 5). In a similar vein, after declining in recent decades, China's participation rate will, in our view, remain broadly constant through 2030 and rise by three percentage points between 2030 and 2040.

Rebalancing will take decades

We project China's investment to GDP ratio will decline gradually due to a prolonged rebalancing act.  Since the mid-2000s, policymakers have tried to rebalance the pattern of growth toward a larger role for consumption and services and a relatively smaller role for investment and industry. However, since around 2015 there has been little to no progress, in part because policymakers respond to growth weakness by supporting investment. Such a regression has been particularly visible during COVID--industry and investment have held up relatively well while consumption and services have been hammered by lockdowns and social distancing (see chart 6). Investment was still 42% of GDP in 2021.

Chart 5

Chart 6

Despite this setback, we expect rebalancing to take shape again over the medium and longer term. The likely retrenchment of the real estate sector and its economic footprint--via demand for inputs such as steel and cement--will be one key driver of this rebalancing.

But, realistically, with the level of the investment to GDP ratio still very high, the capital stock should continue to grow significantly in the coming years, outpacing GDP.   Later, as the investment ratio declines, we see the capital-output ratio peaking. However, that would only be around 2050.

TFP is trickier: but we don't see cliffs

TFP growth will ease further in the coming decades.   Our view assumes a gradual easing because we don't expect that China will give up on productivity enhancing reforms. International economic interaction via trade and investment has boosted technological progress but will face headwinds going forward.

We don't many signs that China's leaders are trying to turn the economy inward.  The report for the CPC's 20th Party Congress in October called for further market orientation and opening-up. Senior leaders repeated the call for further integration with the global economy after the Congress. Also, China's manufacturing sector seems relatively well-positioned to push ahead in growth areas such as the digitization, green transition (including electric vehicles, solar and batteries) and bio-tech. Our view is that reform and changes will continue, at a gradual pace.

We expect China to continue to benefit from international economic interaction but less than in the last decade.  Such interaction will be influenced by both China's policy on opening up and policies by other countries, the U.S. in particular, to decouple economically from China. And these two factors interact.

As noted, in our view China remains interested in opening up to the outside world. But we expect the country to want to integrate further into the global economy on its own terms, with its own, relatively state-led, economic model. That will continue to create friction internationally. Meanwhile, the governments of the U.S. and some other developed countries have become increasingly forceful in trying to decouple their economy at least partly from China's. The U.S. government has taken a range of initiatives to break ties with China's semiconductor industry.

Despite these tensions, given China's market size, growth prospects and manufacturing capability international businesses will remain interested in engaging with China. Nonetheless, because of the increased geopolitical friction, international economic interaction will likely contribute less to China's productivity growth in the coming decades than it has done in recent decades.

In all, in our baseline, we expect China's GDP per capita to rise from 28% of the U.S. level in 2021 (in purchasing power parity terms) to 36% in 2030 and 44% in 2040, a level South Korea reached in 1997. Indeed, we see China continuing to catch up with the U.S. in productivity and living standards, reflecting relatively conducive economic fundamentals.

Some observers are more pessimistic about productivity growth and catchup in China. As noted, one reason we are less pessimistic is that we see the experience of its successful northeast neighbors as a more appropriate benchmark than that of emerging markets generally. Another reason relates to U.S. measures to restrict China's access to advanced technology. Such measures will clearly be a setback for China. However, given the country's currently modest level of overall development, there is still a lot of room for catchup other than by frontier area innovation.

Productivity Surprises Underpin Our Alternative Scenarios

Our downside scenario foresees less domestic reform and opening up by China and more decoupling by the U.S. and other advanced economies. That would result in lower TFP growth and thus lower GDP growth (see chart 7) [1]. In this scenario, to which we assign a probability of 20%, potential GDP growth would decline faster, to 2.9% by 2030 and 2.1% by 2040. Catch up with the U.S. would be significantly slower; by 2040, GDP per capita (in PPP terms) would be only 39.5% of the U.S. level, where South Korea was in 1994 (see chart 8).

Chart 7

Chart 8

Our upside scenario assumes full-throttle policy efforts to boost growth. We also assign a 20% probability to this one. Specifically, it features (1) more initiatives to boost productivity, leading to a halt in the gradual decline of TFP growth; and (2) more efforts to boost labor input as the impact of a falling working age population kicks in. This would result in a less rapid decline in potential GDP growth, to 4.2% by 2030 and 3.3% by 2040. In this scenario, catch up with the U.S. would be significant faster and by 2040 China's GDP per capita (in PPP terms) would be 47.2% of the U.S. level, where South Korea was in 2001.

Notes

[1] Our specific assumption is that China's ratios of imports and exports to GDP decline by 3 ppt. Using results of Silajdzic and Mehic, this leads to an eventual negative impact of 0.45 ppt on TFP growth. An additional 0.3 ppt weakening stems from less progress with market-oriented reform. The impact is phased in over five years.

References

Full references for the two papers referred to in the text are:

• Lant Pritchett & Lawrence H. Summers, 2013. Asia-phoria meet regression to the mean. Proceedings, Federal Reserve Bank of San Francisco.

• Sabina Silajdzic and Eldin Mehic. 2018. Trade openness and economic growth: Empirical evidence from transition economies. Trade and global market, IntechOpen.

Related Research

• China Trades Immediate Economic Growth For Uncertain Benefits, Sept. 20, 2022
• Cutting China From Supply Chains--Easy To Say, Hard To Do, June 1, 2022
• China Credit Spotlight: The Great Game And An Inescapable Slowdown, Aug. 29, 2019