China: The Morphing Dragon

The Chinese economy has changed dramatically over the last three decades. While its per-capita income was only a third of that of Sub-Saharan Africa in 1978, it has now reached an upper-middle income status, lifting more than half a billion people out of poverty. The numbers are dramatic: per capita income has doubled for more than a billion people in just 12 years. What was once a primarily rural, agricultural economy has been transformed into an increasingly urban and diversified economic structure, with decentralization and market-based relations rising relative to the traditional government driven command-based economy.

This extraordinary pace of transformation is poised to continue over the next two decades, as outlined by my World Bank colleague Philip Schellekens in this week's Economic Premise - A Changing China: Implications for Developing Countries. The Chinese pattern of rapid growth with structural change has been accompanied by rising economic imbalances, just as the main pillars of growth seem to be gradually weakening. High and sustained GDP growth rates were based on elevated investment to GDP ratios, which in turn were only possible with low shares of wage income and domestic consumption, cheap and repressed finance. Another factor was dynamic markets abroad willing and capable to absorb a huge Chinese export expansion. Today, the economic doldrums faced by advanced economies are challenging the growth pattern associated with twin current and capital account surpluses. This has meant an accumulation of excessive foreign reserves with growing income disparities that are a domestic flipside of that model (see China 2030).

Philip highlights three mutually reinforcing paths of transformation ahead in the Chinese economy. First, a structural slowdown of growth looks clearly to be in the cards. The productivity increases and growth seen through transferring resources from low-productivity agriculture activities to industry -- a typical feature of economies moving from low- to middle-income levels -- has already happened. On the demographic front, the old-age dependency ratio will likely double in the next two decades. Furthermore, gains in economic efficiency and technological progress based on absorption of existing, imported technologies have now to be increasingly replaced by local innovative efforts. The set of second-generation policy reforms necessary for that will require time to bear fruit.

Second, a rebalance is expected. Higher shares of services and consumption, following rising wages, with a decrease in exports, savings and investment ratios to GDP, will accompany the increased reliance on domestic sources of growth. Government consumption is also to rise, in order to meet social demands, as well as the needs of operations and maintenance. The income gap between coastal areas and middle and western regions will fall as the pool of underemployed labor shrinks. Interestingly, the perception of rising prosperity by the population at large will likely be higher than before, with rising purchasing power, despite somewhat lower GDP growth rates.

Third, a shift up the value chain in both tradable and non-tradable activities will augment the previous paths of change. A transition to more sophisticated production processes is a target being already pursued.

As Philip highlights, given the impact of Chinese economic transformation on the world economy, one may expect to feel the ripples of China's economic metamorphosis abroad in the years ahead.

The Unhidden Dragon

One channel of transmission of China's change shall be through their demand for imports. Its growth rebalancing will tend to favor commodities more associated with consumption, like agricultural goods, while metals and minerals will be negatively impacted in relative terms by the investment slowdown (although the latter may be partially offset by a still rising demand for residential construction and durable goods in the medium term). Meanwhile the rising share of services will lead to import leaks depending on current trends toward increasing tradability. Current imports of capital goods will move toward more sophisticated ranges.

A second channel will be through the erosion of China's current competitive edge on low-cost labor-intensive manufacturing. Notwithstanding some reasons pointed out by Philip for why the out-migration of those activities "may not happen overnight and may never play out fully", a window of opportunity will open to those countries with appropriate endowments and policy actions to benefit from the Chinese domestic factor price evolution.

Finally, a third channel of transmission will be China's march up the value chain, establishing a new front of head-to-head competition abroad. Here, as Philip says, both winners and losers may be produced in the rest of the world, depending on whether a country faces the challenge by introducing its own structural reforms to support innovation and adaptation to the new context, including by strengthening its position in the range of high-end goods and services.

The metamorphosis of the dragon may involve painful growing pains, including the risks of a hard landing that many analysts attribute to the current transition. The forthcoming two decades are setting the next stage of a half-century that could be marked by dramatic economic transformation, creating both challenges and opportunities for China and the rest of the world.

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