Getting used to a slower pace of growth in China

China's middle-income earners are sitting pretty - but can the country gather enough pace to break through and join the rich nations?

After 30 plus years of remarkable growth, China's policymakers have been discussing a key question: When will that trend bend downwards?

They're focused on the "middle-income country trap", where countries escape abject poverty, but slow down so much that they never become rich.

Looking around the world, it becomes clear why.

The Organisation for Economic Co-operation and Development (OECD) estimates that only 17 out of some 200 countries have overcome that trap.

Chinese growth is slowing after an almost unprecedented three decades of strong growth. The question is by how much. The answer matters to us all as we look to China as an engine of growth amid a slowly recovering West.

Slower mover

Evidence of that slowing is already visible. The economy expanded by 7.7% year-on-year in the first quarter, the slowest pace of growth since the Asian financial crisis 13 years ago.

The latest indicators, such as the purchasing managers' surveys, suggest that April was even slower.

But Chinese policy has already shifted. The target is for 7.5% growth this year and until 2020. It suggests that the new "trend" growth rate will be substantially below the 9.6% growth China has averaged since reforms started in 1979.

Even at that pace, China's average income will still nearly double from $9,100 (adjusted for purchasing power) to around $15,000 by 2020, according to IMF estimates.

Copying others' production techniques goes a long way to help growth - but innovation is also needed

But that is the level where the "middle income country trap" lurks.

How China achieves that growth in the next decade will matter for long-term sustainability and its chances of avoiding that trap - will it be through inefficient investment or raising productivity?

Think Greece versus South Korea - which are some of those who have overcome the trap, but in notably different ways.

What drives growth?

I've spent years as an academic economist researching the question of what drives growth in the Chinese economy. Analysing the evidence by breaking down the drivers of growth leads to some surprising conclusions.

About half its growth comes from investment. This is the easier route for China with its state-owned commercial banks, but is not ultimately sustainable if the investment isn't where it's needed.

It could also drag down the banks.

Another 10% to 20% comes from adding workers to the workforce. That looks low, but Chinese women already have high rates of labour force participation after decades of central planning where they worked as much as men.

This leaves about 30-40% of growth which is unexplained by adding workers or capital.

That portion is called total factor productivity (TFP) by economists. TFP is the technology or know-how that makes each worker or machine more efficient. This, though, is too much of a catch-all.

The innovation question

Examination of the numbers shows that there is less TFP than the headline figure suggests.

For instance, state-owned enterprises were downsized from over 10 million to about 250,000 by the end of the 1990s.

The population also became more urban than rural last year for the first time.

These one-off productivity boosts account for up to one-third of TFP growth, but won't be repeated in the same magnitude in the future.

Imitation is another factor to consider - simply copying how more advanced foreign industries do things.

It is how developing countries "catch up".

As they move toward the technology frontier, they can grow more quickly.

Developed countries, which are at or close to the frontier, must innovate to grow and so are slower. China has done well due to its policies that focused on joint ventures (JVs) to allow Chinese firms to learn from more advanced foreign firms.

Know-how transfer

China's slower pace of growth will take some getting used to for both the Chinese and the rest of the world

In the past 30 years, Chinese-foreign joint ventures contributed an average of 9% to total investment funds in the country. This rises to 15% when all forms of foreign investment are counted. Through investing in China, foreign firms contributed up to 0.71 percentage points to growth.

In addition, my research with John Van Reenen of the London School of Economics shows that JVs are 23% more productive on average than other firms. Those which had a technology transfer agreement that directly transferred advanced know-how from the foreign partner to the Chinese firm were 73% more productive.

Since 15% of all firms were JVs during the 2000s, economic growth would have been 0.43% slower each year if China didn't have those more productive joint ventures.

Taking the contributions of foreign investment out of gross domestic product (GDP), China's growth would have been about 1% slower every year. In other words, China would have grown at closer to 8.5% if there had not been "imitation", so putting it closer to India's growth rate.

Once this "imitation" is stripped out from TFP, innovation may account for only 5% to 14% of Chinese growth. The contribution of human capital - the skills of the workforce that make workers more productive - is just slightly higher, accounting for another 11-15%.

This suggests that the sustainable parts of TFP that comes from innovation and skills could be as low as 16%. This is a far cry from the headline figure of TFP generating 40% of growth.

The end of an era

Yet, for China to continue to grow, it needs to encourage technological innovation and human capital.

It can't rely on those one-off structural shifts to raise productivity and there are limits to imitation.

For instance, countries which have become rich like South Korea started off imitating and then moved onto making their own technologically superior products. Just look at Samsung and a host of other household names.

It's one of the reasons why China is "going global" and promoting multinational companies with the hope that they will raise the innovativeness of the country. Without it, productivity and with it economic growth could slow considerably as the old growth drivers become exhausted.

The era of nearly 10% GDP growth is likely to be over.

For the rest of the world - as well as the Chinese people - the new growth rate will take some getting used to. If China succeeds in its technological upgrading, then it could join the ranks of rich countries.

This is perhaps a more meaningful measure than if it overtakes the US as the world's largest economy because it means that Chinese people will enjoy living standards comparable to the West.