China’s economic slowdown — from a nearly 10 percent annual output gain in 2007 to below 8 percent 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 1970s.

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 percent.

This correlation is reinforced by the convergence hypothesis — the benchmark theory for estimating an economy’s potential growth rate.

The theory states that all economies should eventually converge in terms of per capita income. Developing countries have the potential to grow at a faster rate than advanced countries because diminishing returns on capital in particular are not as strong as in capital-rich countries. Further more, poorer countries can replicate the production methods, technologies and institutions of advanced economies.

According to the economists Barry Eichengreen, Donghyun Park and Kwanho Shin, the real growth rate of a rapidly developing economy will slow when the economy reaches about 60 percent 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 percent 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.

But Eichengreen, Park and Shin also found that once this income level is reached, annual growth rates tend to fall by no more than two percentage points.

This means that GDP growth should have slowed gradually in Japan after 1971, instead of plummeting by more than 50 percent. Likewise, given the remaining income gap with the U.S., the Asian Tigers should have grown faster than they have in the last two decades. But they each suffered a substantial slowdown (albeit less sharp than Japan’s).

These inconsistencies can be explained by external shocks — a point emphasized by Hideo Kobayashi in his book “Post-War Japanese Economy and Southeast Asia.” During Japan’s economic boom, its total factor productivity (TFP, or the efficiency with which inputs are used) contributed about 40 percent to GDP growth.

When growth plummeted, TFP fell even faster — a dramatic change that was clearly linked to the 1971 yen appreciation and the 1973 oil crisis.

From a microeconomic perspective, a sudden exchange-rate shock and sharp increase in oil prices impedes firms’ ability to adjust their technology and production methods to meet new cost conditions, eventually undermining TFP growth. Such a cost shock has a more prolonged effect than a negative demand shock.

Without negative external shocks, exorbitant TFP growth would have declined gradually, as the returns from institutional adjustment, reallocation of resources, and technological catch-up naturally diminished, in accordance with the convergence hypothesis.

External shocks also explain China’s GDP slowdown since 2007. The renminbi’s gradual yet sustained appreciation against the U.S., dollar is the cost shock’s main driver, but the demand shock that followed the 2008 global financial crisis aggravated the situation. It is likely that TFP has declined substantially as China’s economy has slowed in response to these shocks.

Unlike Keynesians, who focus on demand shocks, followers of the Austrian economist Joseph Schumpeter view cost shocks as important potential catalysts for structural reform and industrial upgrading — both of which are needed to avoid falling into a low-growth rut in the long term.

In the short term, a cost shock devastates some economic activities, forcing companies either to shut down or move on to another line of business. But what Schumpeter called “creative destruction” can facilitate the eventual emergence and expansion of new, more efficient firms.

The problem is that many country-specific factors, such as political concerns and pressure from vested interests, can impede this process. In this sense, China’s government is facing an important test.

If it fails to take advantage of the opportunity provided by the cost shock and economic slowdown to implement the necessary structural reforms, China’s potential growth rate, as dictated by TFP, will never rebound fully.

Given that improving overall productivity is the best way to defend against cost shocks, the new round of structural reform should be aimed at creating conditions for economic transformation and upgrading.

The key is to establish a level playing field guided by market rules, reduce government intervention in the economy, and stop protecting inefficient businesses. Such efforts would go a long way toward increasing China’s potential growth rate.

Indeed, considering that China’s per capita income amounts to only about 10 to 20 percent of that of the U.S., with massive regional differentials within China, its growth potential, as dictated by the convergence hypothesis, is far from tapped. But the degree to which it can fulfill this potential in the coming decades will depend largely on its TFP prospects.

In 2007, the economists Dwight Perkins and Thomas Rawski estimated that, in order for China’s economy to maintain a 9 percent growth rate and a 25 to 35 percent investment ratio until 2025, it would need to maintain an annual TFP growth rate of 4.3 to 4.8 percent.

Given that China’s TFP growth has averaged 4 percent for more than 30 years, and is likely to slow in the coming decade, this scenario is improbable. Maintaining 6 percent annual GDP growth with the same investment ratio would require annual TFP growth of only 2.2 to 2.7 percent.

With China’s productivity still well below that of developed countries, and allocational efficiency likely to improve in the next 10 years as labor and capital are redistributed across the country, 3 percent TFP growth is feasible.

Aided by structural reforms, China’s economy could expand even faster, achieving 7 to 8 percent annual growth over the next 10 years. Either way, convergence will remain swift.

Zhang Jun is professor of economics and director of the China Center for Economic Studies at Fudan University, Shanghai. © 2013 Project Syndicate (www.project-syndicate.org)

In a time of both misinformation and too much information, quality journalism is more crucial than ever.
By subscribing, you can help us get the story right.