## China’s Path to Sustainable and Balanced Growth

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### Introduction
- China’s economy has started slowing after decades of high growth and faces headwinds projected to lower potential growth substantially in the medium- and long-term.
- Key headwinds identified:
  - Rapidly aging population leading to fewer people entering the labor force (IMF, 2017).
  - Significant slowdown in productivity growth as China nears advanced-economy status (Madsen and others, 2010).
  - Diminishing returns from investment-led growth due to excessive investment financed by record-high domestic savings, channeled to relatively less productive SOEs, real estate, and an already large public capital stock.
  - Intensifying industrial policies that can contribute to capital misallocation and slower productivity growth.
- Modeling approaches used:
  - Production function approach to project potential growth.
  - Dynamic stochastic general equilibrium model to study an illustrative reform scenario and some forecast assumptions.
- Baseline projections (no significant structural reforms):
  - Potential growth could slow to around 3.8 percent on average between 2025-30.
  - Potential growth could slow to 2.8 percent on average over 2031-40.
- Illustrative reform scenario:
  - Potential growth could remain at around 4.7 percent between 2023-38.
  - Reforms that foster rebalancing enhance welfare while being GDP neutral over the long term.
  - The most promising reforms simultaneously: enhance productivity growth, facilitate rebalancing toward consumption, and mitigate demographic headwinds.

### Background: historical growth and drivers
- Historical performance:
  - Average real GDP growth rates of around 10 percent in the 1990s and 2000s.
  - Between 1990 and 2019, China’s growth was 5.5 percentage points higher on average per year than other countries’ growth rates at similar development levels (IMF, 2023).
  - China accounted for around 19 percent of the global economy measured in market US dollar exchange rates in 2023.
- Demand-side imbalances and savings:
  - Household savings driven by precautionary motives and an aging population (IMF, 2022; Zhang and others, 2018).
  - Household savings rate declined to pre-pandemic levels throughout 2023 but remained extremely high by international standards.
  - High savings translated into a low and falling share of consumption and a rising share of investment in GDP.
  - Current account balance fell from around 10 percent of GDP in 2007 to 1.5 percent in 2023.
- Investment composition and risks:
  - Real estate sector accounted for around 20 percent of China’s GDP pre-pandemic.
  - Augmented government debt-to-GDP ratio is estimated to have reached 117 percent by end-2023.
  - Local governments faced financing strains amid large local fiscal gaps, heightened by falling land sales revenues amid the property market correction.
- Productivity and resource allocation:
  - Marginal product of capital has been falling sharply, indicating diminishing returns to investment and possible misallocation.
  - Manufacturing investment grew more slowly in the previous decade with less evidence of excess compared to infrastructure and real estate.
  - Manufacturing productivity growth slowed considerably following the Global Financial Crisis.
  - Firm-level evidence shows responsiveness of capital growth to the marginal product of capital has declined; large productivity gaps between SOEs and private firms persist.

### Key findings and projections
- Decomposition and projection findings:
  - Historical decomposition of growth into supply-side factors informs medium- and long-term potential growth projections.
  - Baseline (no major reforms): potential growth around 3.8 percent (2025-30) and 2.8 percent (2031-40).
  - Reform scenario (productivity-enhancing, rebalancing, and demographic-mitigating measures): potential growth around 4.7 percent (2023-38).
- Welfare and distributional effects:
  - Reforms that foster rebalancing would enhance welfare and are GDP neutral over the long term in the scenarios analyzed.
- Structural transformation:
  - China’s tertiary sector remains relatively smaller than expected for its level of per capita GDP; structural transformation toward services has been delayed by the investment-driven model.
  - Sectoral labor shares show relative underemployment in the tertiary sector compared to international peers for similar development levels.

### Historical Decomposition of Growth — Production Function approach and results
- Framework and parameters:
  - Cobb-Douglas production function: Yt = At Kt^α (Lt ht)^(1−α)
  - Log-linearized growth-rate form: Ŷt = Ât + α K̂t + (1−α) L̂t + (1−α) ĥt
  - Potential growth uses HP-filtered trends: Ỹ̂t = Ẫt + α K̃̂t + (1−α) L̃̂t + (1−α) ĥ̃t
  - TFP as residual: Â̂t = Ŷt − α K̂t − (1−α) L̂t − (1−α) ĥt
  - Elasticities used: α = 0.4 and 1−α = 0.6.
- Data inputs:
  - Real GDP and sectoral GDP from China’s NBS.
  - Total capital stock from Herd (2020), extended via perpetual inventory method; sectoral capital stocks based on Wu (2016) and sectoral shares in fixed asset investment (NBS).
  - Labor proxied by working age population (15-59 for males, 15-54 for females) from UN World Population Prospects 2022; sectoral labor from NBS employment shares.
  - Human capital index from Penn World Tables 10.01.
- Historical decomposition results and key statistics:
  - Aggregate TFP growth fell from 4.1 percent in the 2000s to 2.6 percent in the 2010s.
  - Aggregate TFP growth peaked in 2006 and has trended downward since.
  - Within‑sector TFP growth fell from around 3-5 percent in the 2000s to 2 percent or less in the 2010s.
  - During the 2010s, estimated TFP levels: primary ≈ 78 percent and tertiary ≈ 81 percent of secondary sector TFP (secondary = 100 base).
  - Labor reallocation out of primary into secondary contributed positively to aggregate TFP, but this contribution has been fading.
  - Estimated peak potential growth: around 10 percent in 2006; estimated potential growth in 2022: 5 percent.
  - Historical drivers of the decline in potential growth: weaker productivity growth (largest contributor), less productive capital, and a shrinking workforce.
- Caveats on measured productivity:
  - Historical TFP estimates may overstate sustainable productivity because actual GDP levels were inflated by excessive credit and overinvestment, especially post‑GFC.
  - Nonfinancial private sector credit-to-GDP ratio increased by 45 percentage points during 2012-2016; counterfactual suggests about a 10 percentage point increase absent excessive credit growth.
  - Real estate and other less productive sectors absorbed growing capital, reducing credit efficiency and potentially overstating measured TFP growth.
- Baseline projection inputs and results (summary):
  - Labor: evolves with UN medium fertility scenario; workforce continues to fall.
  - Sectoral labor shares: converge to advanced economy (AE) shares by 2050 absent significant rebalancing.
  - Investment: investment-to-GDP ratio falls by about 1 percentage point in the long term from current level; iterative process finds average investment growth of 2.6 percent in the baseline.
  - Historical investment growth comparisons: real gross fixed capital formation growth of 13.5 percent in the 2000s and 8.0 percent in the 2010s.
  - Real estate investment contracted by about 25 percent over 2021-23.
  - TFP: within‑sector TFP levels move in line with pre‑pandemic linear trend.
  - Baseline projection results:
    - Potential GDP growth projected to slow: average 3.8 percent between 2025-30 and around 2.8 percent on average over 2031-40.
    - These projected potential growth rates compare with almost 8 percent actual real GDP growth (decade before pandemic) and 7 percent real per capita GDP growth over the same period.

### Reforming China’s Economy — Production function reform scenario (assumptions and outcomes)
- Reform timing: reforms phased in linearly over 15 years starting in 2024.
- Main reform assumptions:
  - SOE reforms: close a productivity gap of around 6 percent (assumed to extend to the entire secondary sector) by year 2039.
  - Market dynamism: pro-market reforms boost productivity in the secondary sector by 1 percentage point over the reform horizon.
  - Demand-side rebalancing: budget-neutral re-composition of fiscal expenditures toward households reduces household savings rate; investment-to-GDP share assumed to fall by around 10 percentage points over the reform horizon as it converges to current AE ratios.
  - Sectoral reallocation: faster than baseline; tertiary sector TFP growth improves by 0.05 percentage points per 1 percentage point higher labor share.
  - Retirement age reform: gradually lift retirement age from 60 (male) and 55 (female) to 65; increase by 1 year every 5 years.
  - Education reform: human capital converges to current AE level over the reform horizon, around 10 years earlier compared to the no-reform baseline.
- Projected production-function outcomes:
  - Average GDP growth rates of about 4.3 percent between 2025-40.
  - Per capita growth rate of around 4.5 percent (period 2025-40).
  - Reforms lift the level of real GDP by around 5½ percent by 2030 compared to the baseline.
  - Reforms lift the level of real GDP by around 21 percent by 2040 compared to the baseline.
  - Consumption share of GDP higher by around 13 percentage points in 2040.
  - Improvement in consumption of more than 60 percent over the same period (to 2040).
  - Direct effect on carbon dioxide emissions: reduction of about 12 percent by 2040.
  - SOEs estimated to generate about half of the country’s total greenhouse gas emissions.
  - Under the same fiscal path, higher growth reduces public debt, creating additional fiscal space; corporate debt burden falls mainly because of higher growth.

### Reforming China’s Economy — General equilibrium modeling (GIMF with GVC sector)
- Model and scope:
  - IMF’s GIMF multi-region DSGE model with a global value chain (GVC) tradable sector.
  - 10 regions modeled: United States, EU+, other advanced economies, China, India, Indonesia, Japan, Korea, other Southeast Asia, and rest of world.
- Key model calibrations and parameters:
  - Consumption intertemporal elasticity of substitution common across regions at 0.2.
  - Share of liquidity constrained households: 25 percent for the United States, EU+, other advanced economies, and China; 50 percent for remaining regions.
  - Elasticities of substitution:
    - Demand for goods in the GVC sector: about 0.8.
    - Demand and trade for consumption, investment, and tradable intermediate goods: about 1.5.
    - Domestically produced consumption and investment goods combine non-tradable goods and a tradable goods bundle with elasticity 0.5.
    - Tradable goods bundle elasticity between Non-GVC and GVC tradables: 0.95.
  - Table of preserved elasticity values (as presented):
    - Consumption: - 1.5 1.5
    - Investment: - 1.5 1.5
    - Non-GVC Tradables: - 1.5 1.5
    - GVC Tradables: 0.5 0.8 0.8
- Reform scenario in GIMF and results:
  - Productivity scenario:
    - Reforms increase long-term level of China’s real GDP about 21 percent.
    - Implies annualized GDP growth 1.3 percentage points higher than baseline.
    - Growth assumed to be about 1 percentage point higher than baseline for 15 years.
    - GVC tradables productivity assumed to grow twice as fast as non-tradables productivity.
  - Global spillovers (trade-channel only):
    - Real GDP in the rest of the world increases by about 1.4 percent (equivalent to 0.1 percentage point higher annualized growth).
    - Spillovers largest in other southeast Asia: real GDP increases by about 2.3 percent in the long term.
    - Spillovers smaller in larger advanced economies (Japan, the United States, EU+).
  - Amplified spillovers if productivity dissemination occurs:
    - Spillovers are significantly larger if reforms generate direct productivity gains in other regions; amplification larger for countries further from the technological frontier and with stronger trade links with China.
  - Fiscal rebalancing scenario (modeled):
    - Public investment in China reduced by 0.5 percentage points of nominal GDP per year for 15 years (halving China’s public investment), offset by increased lump-sum transfers to households.
    - Assumption: decline in public investment does not impact overall productivity (marginal productivity of “lost” public investment assumed close to zero).
    - Simulations:
      - Fiscal rebalancing has a small impact on real GDP but is much more significant for household consumption in the short- and medium-term.
      - The boost in consumption in the long term is over 12 percent.
      - Real GDP will peak temporarily in simulations following rebalancing.

### Fiscal Rebalancing in GIMF — Macroeconomic channels and outcomes
- Short-term macroeconomic effects:
  - Output: 0.4 percent higher relative to baseline 3 years after the start of rebalancing.
  - Channels: larger effective multiplier on transfers relative to public investment due to lower import intensity of consumption and forward-looking households increasing consumption in response to higher expected wealth from transfers.
  - External sector: decline in investment import demand leads to exchange rate appreciation pressures; trade balance declines by 0.4 percent of GDP after 3 years.
- Long-term outcomes and structural implications:
  - Long-term GDP: rebalancing is GDP neutral in the long term, but with a strong shift to household consumption.
  - Conditional risk: if lower public investment reduces overall productivity, rebalancing would reduce GDP in the long term.
  - Broader context: China’s potential growth has started falling and several headwinds suggest it will continue to slow, showing the need for comprehensive reforms of China’s growth model.

### Policy recommendations and reform priorities
- Raise productivity:
  - Return to market-based structural reforms addressing productivity issues to lift aggregate TFP.
- Reallocate capital:
  - Reallocate capital between SOEs and POEs and from infrastructure and real estate into more productive manufacturing or services sectors.
- SOE reforms and green innovation:
  - SOE reforms to enhance productivity in use of carbon-intensive inputs and stimulate innovation in renewables.
- Fiscal rebalancing:
  - Rebalance fiscal spending toward social protection to reduce precautionary household savings and support consumption; fiscal rebalancing is modeled as budget-neutral via lump-sum transfers.
- Complementary measures:
  - Strengthen social protection to reduce precautionary household savings.
  - Address financial and fiscal vulnerabilities stemming from high debt levels, including strains among developers, local governments, and local government financing vehicles.
  - Curb excessive credit growth and improve allocation of capital toward more productive uses.
- Expected benefits:
  - Policies would raise growth and output levels, reduce risks, raise welfare, and make growth more sustainable, balanced, and green.

### Limitations and cautions on projections
- Model dependence: projections are conditional on specific modelling assumptions; findings are broadly consistent using two very different approaches.
- Estimation risk: projections are subject to potential under- or overestimation of potential output due to overly pessimistic or optimistic assumptions.
- Recent puzzling dynamics: since 2020 China has experienced low inflation, low nominal growth and weak consumer confidence even though growth rates remained relatively high by upper-middle income country standards; this could imply potential growth was higher than estimates and actual negative output gaps larger than estimated.
- Need for refinement: continued refining of China’s potential growth projections, including alternative analytical approaches, is important during a period of relatively fast structural transformation in China.

*IMF Working Paper: China’s Path to Sustainable and Balanced Growth (Working Paper No. WP/2024/238)*

### References .............................................................................................................

### China’s Path to Sustainable and Balanced Growth

### Introduction
- China’s economy has started slowing after decades of high growth and faces headwinds projected to lower potential growth substantially in the medium- and long-term.
- Key headwinds identified:
  - Rapidly aging population leading to fewer people entering the labor force (IMF, 2017).
  - Significant slowdown in productivity growth as China nears advanced-economy status (Madsen and others, 2010).
  - Diminishing returns from investment-led growth due to excessive investment financed by record-high domestic savings, channeled to relatively less productive SOEs, real estate, and an already large public capital stock.
  - Intensifying industrial policies that can contribute to capital misallocation and slower productivity growth.
- Structural reforms and rebalancing toward consumption are framed as necessary to transition to “high-quality”—balanced, inclusive, and green—growth.
- Modeling approaches used in the paper:
  - Production function approach to project potential growth.
  - Dynamic stochastic general equilibrium model to study an illustrative reform scenario and some forecast assumptions.
- Baseline projections (no significant structural reforms):
  - Potential growth could slow to around 3.8 percent on average between 2025-30.
  - Potential growth could slow to 2.8 percent on average over 2031-40.
- Illustrative reform scenario:
  - Potential growth could remain at around 4.7 percent between 2023-38.
  - Reforms that foster rebalancing enhance welfare while being GDP neutral over the long term.
  - The most promising reforms simultaneously: enhance productivity growth, facilitate rebalancing toward consumption, and mitigate demographic headwinds.

### Background: historical growth and drivers
- Historical performance:
  - Average real GDP growth rates of around 10 percent in the 1990s and 2000s.
  - Between 1990 and 2019, China’s growth was 5.5 percentage points higher on average per year than other countries’ growth rates at similar development levels (IMF, 2023).
  - China accounted for around 19 percent of the global economy measured in market US dollar exchange rates in 2023.
- Demand-side imbalances and savings:
  - Chinese households have historically had an exceptionally high savings rate driven by precautionary motives (gaps in social protection and falling job security) and an aging population (IMF, 2022; Zhang and others, 2018).
  - During the pandemic, household savings increased further; the household savings rate declined to pre-pandemic levels throughout 2023 but remained extremely high by international standards.
  - High savings have translated into a low and falling share of consumption and a rising share of investment in GDP.
  - Current account balance fell from around 10 percent of GDP in 2007 to 1.5 percent in 2023.
- Investment composition and risks:
  - High domestic savings financed rising investment, much of it in infrastructure and housing, and in later years increasingly channeled into less productive sectors.
  - Real estate sector accounted for around 20 percent of China’s GDP pre-pandemic.
  - Excessive credit growth accompanied high savings and investment.
  - Augmented government debt-to-GDP ratio is estimated to have reached 117 percent by end-2023.
  - Local governments faced financing strains amid large local fiscal gaps, heightened by falling land sales revenues amid the property market correction.
- Productivity and resource allocation:
  - Marginal product of capital has been falling sharply, indicating diminishing returns to investment and possible misallocation.
  - Manufacturing investment grew more slowly in the previous decade with less evidence of excess compared to infrastructure and real estate.
  - Manufacturing productivity growth slowed considerably following the Global Financial Crisis (Brandt and others, 2020; Cerdeiro and Ruane, 2022), linked to declining business dynamism and a significant presence of less-productive state-owned enterprises (SOEs).
  - Firm-level evidence shows the responsiveness of capital growth to the marginal product of capital has declined, and large productivity gaps between SOEs and private firms persist (Jurzyk and Ruane, 2021; Cerdeiro and Ruane, 2022).

### Key findings and projections
- Decomposition and projection findings:
  - Historical decomposition of growth into supply-side factors informs medium- and long-term potential growth projections.
  - Baseline (no major reforms): potential growth around 3.8 percent (2025-30) and 2.8 percent (2031-40).
  - Reform scenario (productivity-enhancing, rebalancing, and demographic-mitigating measures): potential growth around 4.7 percent (2023-38).
- Welfare and distributional effects:
  - Reforms that foster rebalancing would enhance welfare and are GDP neutral over the long term in the scenarios analyzed.
- Structural transformation:
  - China’s tertiary sector remains relatively smaller than expected for its level of per capita GDP; structural transformation toward services has been delayed by the investment-driven model.
  - Sectoral labor shares show a relative underemployment in the tertiary sector compared to international peers for similar development levels.

### Policy implications and reform priorities (as emphasized)
- Priority reforms should aim to:
  - Enhance productivity growth across sectors, especially by addressing resource misallocation and boosting private-sector dynamism relative to SOEs.
  - Rebalance demand toward consumption to reduce reliance on investment-led growth and mitigate diminishing returns to capital.
  - Mitigate demographic headwinds by policies that support labor force participation and human capital.
- Complementary measures:
  - Strengthen social protection to reduce precautionary household savings and support consumption.
  - Address financial and fiscal vulnerabilities stemming from high debt levels, including strains among developers, local governments, and local government financing vehicles.
  - Curb excessive credit growth and improve allocation of capital toward more productive uses.

*IMF WORKING PAPERS China’s Path to Sustainable and Balanced Growth — INTERNATIONAL MONETARY FUND*

### 3. Historical Decomposition of Growth

### 3. Historical Decomposition of Growth

### a. The Production Function Approach
- Framework: standard supply-side growth accounting using a Cobb-Douglas production function:
  - Yt = At Kt^α (Lt ht)^(1−α)
  - Log-linearized growth-rate form: Ŷt = Ât + α K̂t + (1−α) L̂t + (1−α) ĥt
  - Potential growth uses HP-filtered trends: Ỹ̂t = Ẫt + α K̃̂t + (1−α) L̃̂t + (1−α) ĥ̃t
  - TFP as residual: Â̂t = Ŷt − α K̂t − (1−α) L̂t − (1−α) ĥt
- Sectoral decomposition:
  - Sector i (primary, secondary, tertiary): Yi,t = Ai,t Ki,t^α (Li,t hi,t)^(1−α)
  - Aggregate TFP decomposed into within‑sector TFP growth and reallocation effects:
    - Â̂t = Σ(Yi/Y) Â̂i + α Σ((Yi/Y − Ki/K) K̂i) + (1−α) Σ((Yi/Y − Li/L) L̂i)
  - Potential growth including sectoral components:
    - Ỹ̂t = Ẫt_within + Ẫt_reallocation + α K̃̂t + (1−α) L̃̂t + (1−α) h̃t
- Parameters and methodological choices:
  - Elasticities used: α = 0.4 and 1−α = 0.6.
  - Trends extracted via Hodrick-Prescott filter.
  - Assumption: α constant across sectors; human capital growth common across sectors (ĥi,t = ĥt).
  - One adjustment: real estate incorporated within the secondary sector (data constraints).

### b. Data Inputs and Construction
- Y, Yi: Real GDP growth from China’s National Bureau of Statistics (NBS); sectoral GDP shares from sectoral real GDP levels.
- K, Ki: Total capital stock from Herd (2020), extended via perpetual inventory method using real gross fixed capital formation (staff estimates based on NBS) and depreciation rates from Herd (2020); sectoral capital stocks based on Wu (2016) for initial period and sectoral shares in fixed asset investment (NBS).
  - Note: investment data based on urban investment, likely underestimating primary sector investment.
- L, Li: Labor proxied by working age population (15-59 for males, 15-54 for females) from UN World Population Prospects 2022; sectoral labor from NBS employment shares.
- H: Human capital index from Penn World Tables 10.01 (average years of schooling and returns to education). For 2020-22, index extended assuming same growth rate as prior years (no pandemic scarring).

### c. Historical Decomposition Results and Key Statistics
- Aggregate TFP:
  - Aggregate TFP growth fell from 4.1 percent in the 2000s to 2.6 percent in the 2010s.
  - Aggregate TFP growth peaked in 2006 and has trended downward since.
- Within‑sector TFP:
  - Within‑sector TFP growth fell from averages of around 3-5 percent in the 2000s to 2 percent or less in the 2010s.
  - Highest TFP levels found in the secondary sector.
  - During the 2010s, estimated TFP levels: primary ≈ 78 percent and tertiary ≈ 81 percent of secondary sector TFP (secondary = 100 base).
- Sectoral reallocation:
  - Labor moved out of primary into secondary sector, contributing positively to aggregate TFP via reallocation effects.
  - Aggregate TFP growth exceeded within‑sector TFP growth because of factor reallocation, but this contribution has been fading as secondary sector employment shares stabilized.
- Potential growth:
  - Estimated peak potential growth: around 10 percent in 2006.
  - Estimated potential growth in 2022: 5 percent.
  - Historical drivers of the decline in potential growth: weaker productivity growth (largest contributor), less productive capital, and a shrinking workforce.
- Caveats on measured productivity:
  - Historical TFP estimates may overstate sustainable productivity because actual GDP levels were inflated by excessive credit and overinvestment, especially post‑GFC.
  - Nonfinancial private sector credit-to-GDP ratio increased by 45 percentage points during 2012-2016; counterfactual (Chen and Kang, 2018) suggests about a 10 percentage point increase absent excessive credit growth.
  - Real estate and other less productive sectors absorbed growing capital, reducing credit efficiency and potentially overstating measured TFP growth.

### d. Baseline Projections and Scenario Inputs (summary)
- Baseline scenario assumptions (no significant structural reforms; return to pre‑pandemic trends):
  - Labor: evolves with UN medium fertility scenario; workforce continues to fall; average retirement age assumed constant (implicit).
  - Sectoral labor shares: converge to advanced economy (AE) shares by 2050 absent significant rebalancing.
  - Human capital: continues to grow at current rate (no lasting pandemic scarring).
  - Investment: investment-to-GDP ratio falls by about 1 percentage point in the long term from current level (based on demographics & income); iterative process finds average investment growth of 2.6 percent in the baseline.
    - Historical investment growth comparisons: real gross fixed capital formation growth of 13.5 percent in the 2000s and 8.0 percent in the 2010s.
    - Real estate investment contracted by about 25 percent over 2021-23.
  - TFP: within‑sector TFP levels move in line with pre‑pandemic linear trend (implying falling sectoral TFP growth rates); sectoral reallocation continues with reallocation share in total TFP gradually falling.
- Baseline projection results:
  - Potential GDP growth projected to slow: average 3.8 percent between 2025-30 and around 2.8 percent on average over 2031-40.
  - These projected potential growth rates compare with almost 8 percent actual real GDP growth (decade before pandemic) and 7 percent real per capita GDP growth over the same period.
- Table 1 (scenario contrasts, summarized):
  - Baseline: Investment-to-GDP falls by about 1 percent until 2050; convergence to AE sectoral shares by 2050; workforce per UN medium fertility; human capital growth unchanged; Ai grows in line with past decade.
  - Reform (summary of alternative scenario):
    - Investment-to-GDP ratio falls to AE average of 22 percent over 15 years.
    - Faster convergence of Ki and Li to AE shares within 15 years.
    - Retirement age gradually increases (females +10 years from 55 to 65; males +5 years from 60 to 65; increases by 1 year every 5 years).
    - Human capital converges to current AE level within 15 years.
    - Secondary sector TFP lifted by 6 percent over 15 years on top of baseline to close SOE productivity gap plus 1 percentage point higher growth over 15 years from higher market dynamism; tertiary sector TFP growth improves with labor reallocation by 0.05 percentage point per 1 percentage point higher labor share.

*Source: IMF working paper chapter "3. Historical Decomposition of Growth" (authors’ estimates and documented data sources).*

### 5. Reforming China’s Economy

### 5. Reforming China’s Economy

### a. A Reform Scenario in the Production Function
- Framework and timing
  - Use of a production function to derive medium- to long-term projection under a reform scenario.
  - Reforms are phased in linearly over 15 years starting in 2024.

- Main reform assumptions (specific production function assumptions referenced)
  - State-owned enterprise (SOE) reforms:
    - Close the productivity gap between SOEs and privately-owned enterprises (POEs) in the manufacturing sector.
    - Jurzyk and Ruane (2021) estimate the counterfactual productivity gap to be around 6 percent.
    - Assume this gap extends to the entire secondary sector and is closed by year 2039.
    - Simplifying assumption: productivity reform alone will not have an impact on rebalancing; tertiary-sector SOE benefits are not considered.
  - Market dynamism:
    - Pro-market reforms boost productivity in the secondary sector by 1 percentage point over the reform horizon (Brandt and others, 2020).
  - Demand-side rebalancing:
    - A budget-neutral re-composition of fiscal expenditures toward households (including strengthening social protection) reduces the household savings rate and rebalances toward consumption.
    - Investment-to-GDP share is assumed to fall by around 10 percentage points over the reform horizon as it converges to current advanced economy ratios, implying an improvement in the ratio of private consumption of a similar magnitude.
    - Sectoral reallocation occurs faster than baseline; higher consumption implies more demand for services.
    - Reallocation of resources from less productive to more productive sectors is assumed to boost tertiary sector TFP growth by 0.05 percentage points per additional percentage point of higher labor share (Nabar and N’Diaye, 2013).
  - Retirement age reform:
    - Gradually lift retirement age from 60 (male) and 55 (female) to 65 over the long term.
    - Retirement age is lifted by 1 year every 5 years.
  - Education reform:
    - Improve access and quality of education so human capital converges to current advanced economy levels over the reform horizon, around 10 years earlier compared to the no-reform baseline.

- Projected macroeconomic outcomes (production-function scenario)
  - Average GDP growth rates of about 4.3 percent between 2025-40.
  - Per capita growth rate of around 4.5 percent (period 2025-40).
  - Reforms lift the level of real GDP by around 5½ percent by 2030 compared to the baseline.
  - Reforms lift the level of real GDP by around 21 percent by 2040 compared to the baseline.
  - Bulk of benefits stem from productivity-enhancing reforms.
  - Consumption impacts:
    - Consumption share of GDP higher by around 13 percentage points in 2040.
    - Improvement in consumption of more than 60 percent over the same period (to 2040).
  - Climate and distributional co-benefits:
    - Direct effect on carbon dioxide emissions: a reduction of about 12 percent by 2040 (Chateau and others, 2022).
    - SOEs are estimated to generate about half of the country’s total greenhouse gas emissions (Clark and Benoit, 2022).
  - Fiscal and financial risk implications:
    - Under the same fiscal path, higher growth reduces public debt, creating additional fiscal space.
    - Corporate debt burden falls mainly because of higher growth.
    - Reduction in saving rates would make the economy less prone to asset bubbles and provide a sustainable driver for non-real estate investment.

### b. The General Equilibrium Modeling Approach (GIMF with GVC sector)
- Model and scope
  - Use IMF’s multi-region dynamic stochastic general equilibrium model, GIMF (Global Integrated Monetary and Fiscal model), complemented by a global value chain (GVC) sector.
  - GIMF comprises 10 regions: the United States, the European Union plus (EU+), other advanced economies, China, India, Indonesia, Japan, Korea, other Southeast Asia, and the rest of the world.
  - The GVC tradable sector is introduced to capture China’s integration into global value chains and roundabout production.

- Key model features (selected)
  - Households:
    - Some households are non-Ricardian, finitely lived, overlapping generations.
    - Remaining households are liquidity constrained and consume all their income every period.
  - Firms:
    - Profit-maximizing firms operate in monopolistically competitive markets and produce non-tradable, non-GVC tradable, and GVC tradable goods.
  - Production:
    - GVC tradables combine capital and labor (Cobb-Douglas) with other GVC goods, sourced domestically and from abroad; used as final goods and intermediate inputs (roundabout production).
  - Trade:
    - Trade in final and intermediate goods is tracked bilaterally.
    - Non-tariff barriers (NTBs) capture barriers to trade and impose iceberg costs.
  - Monetary policy:
    - Each region’s central bank uses an interest rate reaction function; default for China is an inflation-forecast-targeting regime.
  - Fiscal policy:
    - Governments can use public consumption, public investment, lump-sum transfers, tariffs, and taxes.
    - Fiscal authority targets a deficit-to-GDP ratio (consistent with a debt-to-GDP target); default uses lump-sum transfers to maintain the deficit target.
    - Automatic stabilizer: output-gap–based countercyclical variation in general lump-sum transfers in the short term.

- Calibration and parameter values
  - Calibration data source: OECD Inter-Country Input-Output Database for 2018 (OECD, 2021).
  - Consumption: intertemporal elasticity of substitution common across regions at 0.2.
  - Share of liquidity constrained households:
    - Set at 25 percent for the United States, EU+, the other advanced economies, and China.
    - Set at 50 percent for the remaining regions.
  - Elasticities of substitution (key)
    - Demand for goods in the GVC sector: relatively inelastic at about 0.8.
    - Demand and trade for consumption, investment, and tradable intermediate goods: elastic at about 1.5.
    - Domestically produced consumption and investment goods combine non-tradable goods and a tradable goods bundle with elasticity of substitution of 0.5.
    - The tradable goods bundle is assembled from tradable intermediate goods and GVC goods with an elasticity of 0.95.
  - Table 3 (Key Elasticities of Substitution in Production and Trade) — preserved values:
    - Consumption: - 1.5 1.5
    - Investment: - 1.5 1.5
    - Non-GVC Tradables: - 1.5 1.5
    - GVC Tradables: 0.5 0.8 0.8
    - Note: There is also an elasticity of substitution to produce an overall tradable goods bundle between Non-GVC and GVC tradables equal to 0.95. The 0.8 is the elasticity between domestic and imported when using GVC goods in the production of final goods or of other GVC goods.

- Reform scenario in GIMF and results
  - Productivity scenario:
    - Reforms that increase long-term level of China’s real GDP about 21 percent.
    - Implies annualized GDP growth 1.3 percentage points higher than baseline.
    - Growth assumed to be about 1 percentage point higher than baseline for 15 years.
    - Given larger productivity gaps in China’s GVC tradables sector, GVC sector productivity is assumed to grow twice as fast as non-tradables productivity.
  - Global spillovers (trade-channel only)
    - Real GDP in the rest of the world increases by about 1.4 percent (equivalent to 0.1 percentage point higher annualized growth).
    - Spillovers largest in other southeast Asia: real GDP increases by about 2.3 percent in the long term.
    - Spillovers are smaller in larger advanced economies (Japan, the United States, EU+).
  - Amplified spillovers with productivity dissemination
    - If reforms also generate direct productivity gains in other regions, spillovers are significantly larger (capturing technology embodied in imports and dissemination effects).
    - Amplification larger for countries further from the technological frontier and with stronger trade links with China (e.g., other southeast Asia).
  - Fiscal rebalancing scenario (modeled in GIMF)
    - Public investment in China reduced by 0.5 percentage points of nominal GDP per year for 15 years (halving China’s public investment), offset by an increase in social protection for households via lump-sum transfers to all households.
    - Assumption: decline in public investment does not impact overall productivity (marginal productivity of “lost” public investment assumed close to zero).
    - Simulations:
      - Fiscal rebalancing has a small impact on real GDP but is much more significant for household consumption in the short- and medium-term.
      - The boost in consumption in the long term is over 12 percent.
      - Real GDP will peak temporarily (simulation details and temporal profile in model results).

*Source: IMF Working Paper — chapter "5. Reforming China’s Economy" (wpiea2024238-print-pdf).*

### 0.4 percent higher relative to baseline 3 years after the start of rebalancing. The larger effective multiplier on

### Fiscal Rebalancing in GIMF (excerpt)

### Short-term macroeconomic effects
- Output: 0.4 percent higher relative to baseline 3 years after the start of rebalancing.
- Channels: The larger effective multiplier on transfers relative to public investment reflects the lower import intensity of consumption and, in the short-term, the presence of forward-looking households who increase their consumption to reflect the higher level of wealth from the increasing stream of fiscal transfers to households over the next 15 years.
- External sector: The decline in investment import demand leads to exchange rate appreciation pressures, with the trade balance declining by 0.4 percent of GDP after 3 years.

### Long-term outcomes and structural implications
- Long-term GDP: In the long term, rebalancing is GDP neutral, but with a strong shift to household consumption.
- Conditional risk: If lower public investment were to reduce overall productivity, rebalancing would reduce GDP in the long term.
- Broader context: China’s potential growth has started falling and several headwinds suggest it will continue to slow, showing the need for comprehensive reforms of China’s growth model. With an ageing population, slowing aggregate productivity, as well as record-high investment rates that have pushed investment into less productive sectors, potential growth under a medium- to long-term baseline scenario is expected to fall.
- Downside risks: Additional downside risks, such as geoeconomic fragmentation and reduced technology knowledge exchange amid technological decoupling, could further dampen medium- to long-term prospects.

### Policy recommendations under a comprehensive reform scenario
- Raise productivity: Return to market-based structural reforms addressing productivity issues could lift aggregate TFP.
- Reallocate capital: Reallocating capital between SOEs and POEs and from infrastructure and real estate into more productive manufacturing or services sectors would help lift overall productivity.
- SOE reforms and green innovation: SOE reforms to enhance productivity in the use of carbon-intensive inputs, while stimulating innovation in renewables, could also support growth.
- Fiscal rebalancing: Fiscal rebalancing towards more social protection would rebalance away from excessive, low-productivity investment, moving to more consumption-based growth while being GDP neutral.
- Expected benefits: These policies would not only raise growth and output levels, but reduce risks, raise welfare, and make growth more sustainable, balanced, and green.

### Limitations and cautions on projections
- Model dependence: Projections are conditional on specific modelling assumptions; findings are broadly consistent using two very different approaches.
- Estimation risk: Projections are subject to potential under- or overestimation of potential output due to overly pessimistic or optimistic assumptions.
- Recent puzzling dynamics: Since 2020 China has persistently experienced low inflation, low nominal growth and weak consumer confidence even though growth rates were still relatively high by upper-middle income country standards. This could be consistent with a scenario in which potential growth was higher than our estimates in the recent past, and actual negative output gaps were larger than estimated.
- Need for refinement: Continued refining of China’s potential growth projections, including with alternative analytical approaches, could help address some of these concerns. This will be particularly important during a period of relatively fast structural transformation in China.

*IMF Working Paper: China’s Path to Sustainable and Balanced Growth (Working Paper No. WP/2024/238)*

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_Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024238-print-pdf.pdf_