China: Towards a more innovative and greener economy
In the years since we started to publish our long-term projections for the Chinese economy, we have been highlighting a number of important long-term trends in the world’s second-largest economy (and possibly the largest by the end of the decade).
The first is that China’s growth rate will likely continue to decline due to several factors. The first is a declining labour force. This is pushing up the cost of labour and eroding the demographic dividend that China has enjoyed since it started opening up to the world in the 1980s. Second, the low-hanging fruits of institutional reforms that transformed the Chinese economy from a strict planned/command economy to a largely market-driven one have already been picked. Additional reforms to unlock further potential tend to be much more difficult to implement. Third, China has already harvested the rapid productivity gains to be had from catching up by using existing technologies. To further enhance productivity, China will have to rely increasingly on original R&D, the gains from which tend to be much slower to appear. Last but not least, ‘strategic competition’ has led to a broad-based deterioration in relations between China and the US (and some US allies). The more challenging external environment will also likely weigh on Chinese growth ahead.
In the meantime, the structure of the Chinese economy continues to change (see chart 1). On the demand side, household consumption will likely gain in importance relative to fixed investment and net exports. The expansion of consumption is mainly being driven by rising income per capita, and particularly the growth of the middle class. The rapid ageing of Chinese society may also play a role, with a bigger share of the population turning from net savers to net consumers after reaching retirement age. The ‘dual-circulation strategy’ laid out by the Chinese government in mid-2020, which puts a special emphasis on domestic demand, could be another catalyst for this trend.
In March 2021, the Chinese legislature approved the 14th five-year plan (FYP) covering the years 2021-2026 and discussed strategic plans up to 2035. China’s plans in two areas in particular could have an especially large impact on the future direction of the Chinese economy.
The first is the government’s much greater emphasis on technology and innovation. The objective is to achieve a greater degree of self-sufficiency in some key technologies such as semi-conductors. Innovation, the ultimate way to achieve productivity growth, is set to be the main source of growth for China in the years to come. Elevated US-China tensions and the US’s ability and willingness to use its existing technological advantages against China provide an added incentive. Indeed, technological rivalry between the two powers is likely to persist over the long haul.
While an average GDP growth target is ostensibly missing from China’s 14th FYP, for the first time the government has set a specific growth target for R&D expenditure— over 7% per annum in the period 2021-2025. China is also investing heavily in human capital. In 2016, 1.76 million primary degrees in science and engineering were awarded, more than double the number in the US and EU and more than four times more than at the beginning of this millennium (see chart 2). In short, we believe innovation will be an increasingly important growth driver for China in the years to come.
The second important leg in China’s strategic plans is the transition towards a ‘greener’ Chinese economy, with President Xi Jinping’s pledging to achieve carbon neutrality by 2060.
Achieving carbon neutrality will require massive change and an overhaul of China’s energy sector. The ‘energy revolution’, combined with the Chinese government’s strong innovation push, could be a catalyst that further boosts China’s leadership position in green technologies such as wind and solar energy.
Growth down, inflation up
With these factors in mind, we expect Chinese growth to trend downward in the decade ahead after the disruption caused by the pandemic and subsequent rapid recovery fade. The decline in growth could become sharper after 2030 when China’s carbon emissions are set to peak and it starts to take more pains to phase out carbon-intensive power generation and manufacturing capacity on a large scale. Taking into account the possible impact of policies to achieve China’s climate goals, we expect the annual Chinese growth rate to decline to 4.3% by 2031 from 6.0% in 2019.
Structural factors could change long-term price dynamics in China, the most important of which is the shrinking labour force. Of course, some structural factors that have put downward pressure on inflation in the past will likely continue to be at play, especially technological advances, while evidence from countries like Japan points to ageing population being a force for deflation rather than inflation. But balancing the various inflationary and deflationary forces at work, we think inflation in China is likely to increase moderately in the coming 10 years. By 2031, we expect headline inflation to reach 3.1% compared to an average of 1.9% in the previous two decades.
Changing inflation dynamics in China may have implications for the rest of the world. With China’s accession to the World Trade Organisation in 2001, half a billion low-cost workers joined the global labour force. Now this trend is reversing. With its rising labour costs and some de-globalisation, China likely will, at the very least stop, being an exporter of deflation going forward.
This article is part of our Horizon publication, contact us for more information.