Fu Jun, Professor of Political Economy and Public Policy, Peking University

Caesar non est supra grammaticos. Essentially the Latin phrase says that without sound structure to organize our observations, phenomena would mislead us. In that spirit, what I will do here is to try to shed some light on what "new normal" growth and "supply side" reforms ought to mean in the Chinese context, and I will do so by drawing on the theoretical insights of the Gaussian normal distribution and the Cobb-Douglass production function. A few concluding remarks follow at the end of my speech regarding some of the principal challenges that China faces in the years ahead.

New Normal Growth 

For us to understand what "new normal" growth means in the Chinese context, let me begin by sketching a board picture of the Chinese economic performance in the past and at the present in a comparative global perspective, and try to project it a bit into the future with the help of the conceptual framework of Gaussian normal distribution. To avoid seeing trees without seeing the forest, let me outline the contour of our picture with some rough estimates. 

According to Angus Madison, 200 years ago Chinese population was roughly 1/3 of the world’s total, and at the time China was producing roughly 1/3 of the world’s total GDP. 100 years later China’s share of the world’s total GDP declined to about 10%, and it dropped further down to about 3% in the late 1970s. Today, the Chinese population has about 1.3 billion, or roughly 1/5 (or 20%) of the world's total, and now, after three decades of rapid economic growth, the aggregated size of the Chinese economy has come back to roughly 13% of the world’s total GDP, which is about US$80 trillion in 2015. 

Although yearly growth rates of the Chinese economy have slowed down significantly in recent years (eg, 6.9% in 2015 as officially stated), for much of the past three decades China has indeed stunned the world by an annualized growth rate of close to 10%. In fact, its growth seems so dramatic that many scholars and observers in the world have described it as a miracle.   

Yet, if we use the conceptual framework of Gaussian normal distribution to organize our observations, the Chinese growth story may not seem as dramatic as has otherwise demonstrated. Measured by GDP per capital growth (ie, total GDP divided by total population), and in comparison with the rest of the world, the Chinese economic performance in recent decades is actually a story of "normalization" towards (not deviation from) the global "norm" in the Gaussian scheme (see Figure I). Put differently, what we observe here is basically a story of "catch up", if you may, from an extremely low base.

Here, as we can see, some 30 or so years ago, China started as a case of extreme variance in the negative territory of performance measured by GDP per capital. But it has since moved rapidly towards the global "norm" -- a "catch-up process" if you may -- thanks to its market-oriented reforms and opening programs, a good example of which was its decision to enter into the world's trading system, the WTO -- a market-based system that has allowed China to take full advantage of its comparative advantages in the global value-chain of production and associated consumption. As a result China has become the world's manufacturing center in the past decade. And it is this institutional foundation, I would argue, that has made China's hitherto export-oriented growth model possible. On the flip side though, it also follows that export declines would put downward pressure on growth unless domestic consumption picks up the slacks to reach a new equilibrium. 

Indeed, rebalance from export to domestic consumption must be a key ingredient of the Chinese prospects of "new normal" growth, now that Chinese exports have gone from the highs of 20-30% a few years ago to the current negative growth rate in 2015. Globally, world trade has slowed down significantly from about 5% (since the 1990s) and about 2.4%, according to the WTO.

With an aggregate GDP of US$10 trillion, China has now become the second largest economy in the world, next only to the United States (US$17 trillion). But I would argue that China still has great potential for further growth. As the Gaussian framework indicates, 20% of the world’s population, ceteris paribus, should produce roughly 20% of the total GDP of the world. But the current figure for China is only 13%. Thus, there still is a gap of 7% of the world's GDP -- or about US$5.5 trillion in current value -- for China to fill up, if the Chinese economy performs "normally" (not extraordinarily) well in the Gaussian sense. Until then, I would argue, that China continues to under-perform its potential. 

Read in this light, the latest Chinese 13th Five-Year Plan, which starts this year, all aims to close this gap. In China's long trajectory of catch-up, it is like the last leg of a multi-staged ascendance out of a valley before China reaches the global "norm" (the world average GDP per capita is US$10,500, according to the World Bank) and then enters the positive territory of variances in the Gaussian framework (where the US is just an example with GDP per capital above US$40,000). But there is a huge difference between "catch up" and "push frontier". Here let me use the analogy of jumping heights to illustrate the point. As you go further up, the rate of progress will perforce slow down.

Thus, "new normal" growth in the Chinese context also means that growth will continue but growth rates will perforce slow down, if only because the base figure has grown so much larger, now at US$10trillion. Even assuming a growth rate of 6.5% (ie, an annualized growth rate that the 13th Five-Year Plan aims at), the Chinese economy will have to grow much more (US$10 trillion*6.5%) each year in absolute terms than that of the United States at a growth rate of 2.2% (US$17 trillion*2.2%), or that of the EU at a growth rate of 1.5% (US$15 trillion*1.5%). Otherwise, China will not be able to reach its objective of having a per capita GDP over US$12,000 by 2020, as envisioned by the 13th Five-Year Plan.

Supply Side Reforms

Thus far I have sketched a rough contour of the Chinese growth potential in the years ahead, with the help of the conceptual framework of the Gaussian normal distribution. But we know that potential wouldn't automatically turn into reality without the right conditions to support growth. Indeed, of late there has much talk about the necessity of "supply side" reforms in China. To understand the debate in the Chinese context, let me nevertheless begin by drawing on the theoretical insights of Cobb-Douglas production function so as to help structure our observations. 

Simply put, the Cobb-Douglas production function says that growth is a function of [R (resource), L (labor), and K (capital)]. I put the mathematically more sophisticated expression of the equation in the footnote.  

On the right-hand or "supply side" of the equation, and implicit (although not explicit) in the model, theoretically speaking, there are two extreme ways of mixing factors of production (R, L, K), both are institutional, and therefore, almost by definition, invisible: one is plan (or more in line with Keynesian approach), the other is market (or more in line with Adam Smith's approach). As one can imagine, different configurations of the two extremes may cause variations in allocative efficiency or in the residue of the equation called TFP (total factor productivity).  

Viewed in this light, the essence of "supply side" reforms is not something new in the Chinese context. As a matter of fact, the whole reforms and opening-up process in China as a transitional economy in the past 30 or so years has been a process of "supply side" reforms, ie, generally moving away from the plan and towards the market. The process has been by and large "market-oriented". In this context, the most important work of "supply side" reforms in China, I would argue, is institutional not just technical. In other words, China ought to continue and deepen market-oriented reforms, and to establish the rule of law (not just rule by law). For markets and the rule of law go hand-in-hand. In economic analysis, the rule of law, by provisions of transparency and predictability, reduces transaction costs.      

Beyond the importance of institutions as foundations for sustainable economic growth, the Cobb-Douglas model has more to tell us in terms of "supply side" reforms in the Chinese context. More technically, the model in turn can be viewed as having two modes of growth, extensive and intensive. Here, the extensive mode can also be expressed as comparative advantage due to better endowments of nature. And the intensive mode, on the other hand, can be expressed as competitive advantage by focusing on the quality rather than quantity of inputs through innovations, which in turn have a lot to do with the quality of education. We know that it is human creativity and ideas that ultimately matter.

Viewed within this framework, China’s growth in the past has basically been driven by the extensive mode, relying more on quantity than quality. Capital formation in China, ie, investment as a share of GDP, has been too high to be sustainable in the long term (eg, in 2014 it is 46% in China, 19% in the US and Germany, 21% in Japan, 29% in South Korea, 24% in Hong Kong, 20% in Russia and Brazil and 32% in India). Apparently, for its growth to be sustainable years down the road, China has to shift gears and deepen "supply side” reforms, ie, from the extensive mode into the intensive mode of growth, if only for two simple but powerful reasons: 

1, In terms of energy and natural resources (i.e., the R variable in the model), constrains have been rising, as there are already high degrees of pollution in its soil, water, and air, and related are the ecological concerns of climate change. 

2, In terms of demographics (i.e., the L variable in the equation), while Chinese total population is projected to rise until around 2025, the productive portion (age 15-60)  peaked in 2015, causing wages to rise rapidly. Academically there is a growing consensus that China has hit the "Lewisian turning point".

Thus, under the twin pressure of the powerful structural forces outlined above, unless innovations, including institutional reforms and innovations, quicken steps to arrest, offset, and reverse the process, the recent growth slow-downs of the Chinese economy, in spite of very powerful stimulus packages,  can be seen as the early signs of a gradual downward regression line towards to the world’s growth average in the past three decades, i.e., in 3-4% range. For international perspectives, when Japan came down from its growth peak in the early 1970s, it dropped rapidly to 4%. Similarly, South Korea went down to 5%; Taiwan to about 6%.

Concluding Remarks

Let me conclude by offering some additional observations. In "new normal" growth and "supply side" reforms, and in the face of the slow-downs of growth rates, China has to do more beyond short-term counter-cyclical fiscal and monetary measures. The Keynesian approach, I would argue, is perhaps appropriate for the short term, but it is certainly not the prescription for the long term. Or, overcapacities, zombie firms, and NPLs (non-performing loans) have already resulted and may continue to accumulate,  and there has already been excessive money supplies (eg, M2/GDP is 2.3 in China in comparison with 1.6 in Japan, 1.3 in South Korea, 0.9 in EU, and 0.6 in the US).

Moving forward, the key here has two dimensions: one is to continue to increase allocative efficiency via what Smith calls "the invisible hand"; the other is what Schumpeter calls "creative destructions". That is, in the case of China, to continue to close the moving line of technology frontiers between itself and advanced economies, including institutional learning, reforms and innovations.

Looking ahead, many of the challenges China must overcome are institutional in nature. Principally, while China has thus far set up competitive markets for goods and services, it is yet to level the ground for factor inputs. As such, China is still halfway between plan and market. The state, to a significant degree, still controls factor inputs through various forms of administrative monopolies favoring powerful interest groups. And in the absence of the rule of law (rather than rule by law), power tends to beget power, which in turn will give rise to two negative consequences: One is rampant corruption, as paradoxically evidenced by China’s current high-profile anti-corruption campaigns; the other is wealth polarization, as evidenced by China’s high Gini-coefficient, hovering around 0.5. 

To sum up, I would argue that the thrust of new normal growth and supply side reforms in Chinese context is well mirrored by the unfinished agenda of the twin tasks set by the 3rd Plenum of the 18th Chinese Communist Party Congress in November 2013. That is, "deepening market reforms" and "setting up the rule of law". And this time, "deepen market reforms" means "let the market play a decisive role of in resource allocation" (note, not just markets of goods); and "set up the rule of law" mean that "the rule of law" is a new concept, different from "rule by law" (note, that rule of law and "rule by law" in Chinese pronunciation are the same, although their written forms are different, thus causing considerable confusion). 

As is true elsewhere, well-functioning markets underpin prosperity, but markets and the rule of law are the two sides of the same coin. Here, China is no exception, and will be a case of convergence rather than divergence. Poet Robert Frost once said philosophically: 

“Most of the change we think we see in life is due to truths being in and out of favor.