Chief China Strategist
Key Points:
In the late 1980s, Japan was hailed as an economic powerhouse poised to overtake the United States. Its meteoric rise seemed unstoppable, fuelled by a potent combination of high savings, cutting-edge technology, and a diligent workforce. Then, in the 1990s, asset prices collapsed, and what was supposed to be a temporary setback morphed into a chronic slower rate of growth that persisted to recent times. The consensus diagnosis was straightforward – Japan was gripped by systemic deflation and a chronic aggregate demand shortfall requiring aggressive monetary and fiscal stimulus.
However, economist John Cochrane (2024) offers an alternative take. He points to microeconomic forces – a declining working-age population and the natural deceleration that occurs when an economy reaches the productivity frontier or limit after an initial catch-up phase, as the root cause of the slowdown. According to Cochrane, Japan's so-called "lost decades" were not a result of insufficient demand but rather a consequence of the country reaching the limits of its productivity growth.
In many ways, China's economic ascent over the past few decades has mirrored Japan's experience, albeit on a more explosive scale. Since embarking on its marketisation and privatisation reforms in the late 1970s, China has witnessed perhaps the most dramatic and geographically expansive economic catch-up in contemporary history. By unleashing the productive potential of its urban and vast rural populations through economic reforms and integrating into global supply chains, China rapidly narrowed the income gap with advanced economies. From 1978 to 2022, its GDP per capita soared from just 1.2% to around 18.4% of US levels at constant US dollars, according to World Bank data.
However, there are growing signs that China's catch-up phase may be losing steam. In addition to the woes of a declining working-age population, China's productivity growth has slowed markedly in recent years. Total factor productivity growth's contribution to China's real GDP growth has declined from over 4% in the mid-2000s to around 2.5% recently. Economists predict it may drop further to an average of 1.3% over the next 10-15 years, potentially limiting China's economic growth rate (Peschel & Liu, 2022).
Amid the sputtering economic momentum, a chorus of voices has urged more aggressive fiscal and monetary stimulus measures in China. The argument is familiar - inadequate demand lies at the heart of China's woes, requiring proactive government spending and easier credit to rekindle the engines of economic activity. However, this Keynesian diagnosis may be misguided. What if, like Japan before, China's slowdown stems not from insufficient demand but from deeper microeconomic forces that defy simplistic stimulus remedies?
This emphasis on the microeconomic foundation of growth has been advanced by the economist John Cochrane in his analysis presented at last month’s BOJ-IMES Conference of the Japanese economy which resonates with this author's perspective expressed in previous articles such as this one on the crux of the economic slowdown in China in recent years. If Cochrane's thesis about Japan holds true for China, the country's primary challenge is not inadequate demand but rather addressing the microeconomic bottlenecks impeding further productivity gains and income convergence with advanced economies.
This brings us back to the reform proposal by Chinese economist Zhou Qiren, which suggests that institutional and system-wide reform has been the key to China's success in closing the income gap with advanced economies. For details about Zhou’s thesis, you can refer to our article on June 3.
Market pundits' reliance on Keynesian-style aggregate demand-boosting stimulus policies is unlikely to raise China's productivity growth rate. The solution lies in institutional and system reforms that address the microeconomic barriers to productivity growth. Asset prices reflect the anticipated long-term growth of the economy. When the economy hits its microeconomic barrier and starts growing at a stagnant long-term rate, asset prices no longer include the option of greater growth and may collapse. On the other hand, when reform brings about a move higher on the expected path of economic growth, asset prices will respond favorably.
As China navigates its economic transition, it is crucial to recognize that the challenges it faces are not a matter of insufficient demand but rather a reflection of deeper microeconomic forces. Simplistic stimulus measures may provide temporary relief but are unlikely to address the root causes of the slowdown.
Instead, China must focus on implementing comprehensive reforms that address the institutional and systemic bottlenecks hindering productivity growth. By fostering an environment conducive to innovation, entrepreneurship, and efficient resource allocation, China will have a better chance to unlock its full economic potential and enhance long-term growth. The path forward may be arduous, but the rewards of successful reform could be transformative, potentially propelling asset prices, including equities, in China higher. However, it remains to be seen if China will choose to move in that direction at the upcoming Third Plenary Session.
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