China’s Untapped Growth Potential

SHANGHAI – China’s economic slowdown, from a nearly 10% annual output gain in 2007 to below 8% today, has fueled widespread speculation about the economy’s growth potential. While it is impossible to predict China’s future growth trajectory, understanding the economy’s underlying trends is the best way to derive a meaningful estimate.

Whereas short-term demand largely dictates an economy’s real growth rate, its potential growth rate is determined on the supply side. Some economists – citing indicators like investment ratios, industrial value-added, and employment – compare China to Japan in the early 1970’s. After more than two decades of sustained rapid growth, Japan’s economy slackened considerably in 1971, leading to four decades of annual growth rates averaging less than 4%.

This correlation is reinforced by the convergence hypothesis – the benchmark theory for estimating an economy’s potential growth rate – which states that a rapidly growing developing economy’s real growth rate will slow when it reaches a certain share of the per capita capital stock and income of an advanced economy. According to the economists Barry Eichengreen, Donghyun Park, and Kwanho Shin, that share is about 60% of America’s per capita income (at 2005 international prices).

At first glance, the experiences of Asia’s most advanced economies – Japan and the four “Asian Tigers” (Hong Kong, Singapore, South Korea, and Taiwan) – seem to be consistent with this theory. In 1971-1973, Japan’s per capita GDP fell to roughly 65% of that of the United States in purchasing-power-parity terms, while the Asian Tigers experienced economic downturns of varying degrees when they reached roughly the same income level relative to Japan.