China: Weak Domestic Demand Now Threatens Growth Potential – Analysis

By Yang Yao*

Forecasts for China’s economic growth in 2023 diverge widely. While international organisations and China watchers abroad predict growth of 4 per cent as reasonable, most Chinese economists believe that growth of 5–6 per cent is more likely.

The debate has a lot to do with assumptions about China’s potential growth rate. Many models can be used to estimate the potential growth rate, but the simplest and most credible is the Solow model. Based on this model, a country’s GDP growth rate depends on the growth rates of its stock of net capital, its population size and its total factor productivity.

China’s population has now stalled and its capital growth depends on its national savings. On this count, China has an edge, with national savings accounting for 45 per cent of its GDP. China’s stock of net capital is 3.6 times its GDP and its depreciation rate is 5 per cent. This means that its annual savings translates into 7.5 per cent growth in its net capital stock.

GDP growth brought about by capital accumulation would be half of this, or 3.75 per cent. Previous studies have found that total factor productivity growth contributes 20–40 per cent of GDP growth. Based on this arithmetic, China’s potential growth rate in 2023 is in the range of 4.7–6.3 per cent, justifying Chinese economists’ forecasts.

But China faces several challenges along the way to achieving this potential growth rate in 2023.

The first is how the COVID-19 pandemic will continue to evolve. Chinese authorities lifted the country’s strict zero-COVID policy in early December 2022. Infections quickly peaked in most provinces but the travel and retail sectors bounced back soon after. The uncertainty is whether a second wave of infections will come in the spring and how severe it will be. Considering this uncertainty, we should not expect high rates of growth in the first two quarters of the year.

The Chinese government should make preparations for a second wave of infections. This includes promoting vaccination, increasing ICU capacity and shoring up medical supplies.

The second challenge is declining external demand. The bottleneck to growth of China’s economy is clearly on the demand side — on average, 20–30 per cent of production capacity is idle.

Over the past three years, the Chinese government has relied heavily on investment to boost demand. But the incremental returns on this investment are diminishing. Capital formation has at best contributed 2 percentage points to China’s growth in recent years.

Exports have made a significant contribution to sustaining China’s growth over the same three years. But as recession fears loom large across the global economy, external demand is likely to falter in 2023. China must shift to domestic consumption to generate enough demand to maintain its growth.

This leads to the third and toughest challenge for China’s growth in 2023. Before COVID-19, domestic consumption grew by a respectable 7 per cent most years. The share of GDP attributable to domestic consumption increased from 48 per cent in 2010 to 55 per cent in 2019. But over the past three years, domestic consumption has slowed. For China to reach a potential growth rate of 5.5 per cent in 2023, consumption growth will need to make up at least 3.5 percentage points of this. This would require consumption growth of at least 6.36 per cent, which is by no means an easy task.

Two factors will help boost consumption. One is the recovery of consumer confidence after the pandemic. This may help release the excess savings accumulated by households over the past three years. Judging by the quick recovery of the travel and retail sectors after the first wave of infections, there is reason to believe that consumption will bounce back in 2023.

The other factor is the stabilisation of the property sector. Due to government attempts to prevent overheating, the property sector underwent a large decline in 2022. The Chinese government began to reverse policy in late 2022 and is now encouraging local governments to support the sector. As a result, the property sector should stop its decline in 2023, and that will have a positive impact on consumption.

But those two factors may still not be enough to generate 6.36 per cent growth in domestic consumption. Chinese authorities have put boosting consumption as a top priority for 2023 and may roll out more policies with this as a goal.

Several local governments have issued coupons to help boost consumption. Consumption coupons are equivalent to price discounts and in most cases are redeemable for a discount of 20 per cent on designated purchases. The problem is that these coupon schemes are still very small in scale. In a province with an economy worth 7 trillion yuan — about US$1 trillion — the latest coupon scheme was only worth 200 million yuan (around US$30 million), too small to generate any noticeable effect.

Preliminary calculations show that GDP growth will increase by 0.78 per cent for every 1 per cent of GDP spent on consumption coupons. This is conditional on a lack of restrictions being placed on the items that coupons can buy — right now, coupons can only be used on designated products. Coupons could also help boost confidence in the Chinese government’s commitment to its pro-growth policies and may bring extra growth in consumption as a result.

If China is to reach its potential for GDP growth, the government will need to continue to advance these pro-growth policies, and make further efforts to promote domestic consumption.

*About the author: Yang Yao is Cheung Kong Scholar and Liberal Arts Chair Professor, Dean of the National School of Development and Director of the China Centre for Economic Research at Peking University.

Source: This article was published by East Asia Forum