Too Large To Grow So Fast

In a way, the commodity-price-led inflation surge of the past year was a message from the marketplace that there are limits to China's growth potential. It is not feasible for an economy to keep growing at a double-digit pace once it achieves a certain critical mass.

The Japanese case is telling. Back in the 1970s, Japan was forced to allow domestic prices and its exchange rate to be more market-determined—all part of an economic evolution process, as larger economies require greater currency flexibility to better tailor domestic money and credit conditions to local needs. Productivity growth in Japan naturally slowed as the exchange rate became less globally competitive, and economic growth averaged 4 percent over the next 15 years.

To be sure, China is not likely to slow to 4 percent growth for some time. China has also moved toward greater exchange-rate flexibility, beginning in 2005, but more gradually than Japan, and it still has a long way to go before it achieves anywhere near the level of modernization that Japan had reached in 1973. China started its modernization drive from a much lower base in 1978, while Japan was already a relatively advanced industrial economy, with modern textile, steel and shipbuilding sectors, at the beginning of its high-growth period in 1955.

Furthermore, China's labor-productivity boom has been driven by the vast migration of rural workers to higher-value-added urban jobs. An estimated 12 million to 15 million people continue to shift from agricultural to manufacturing- and services-based jobs every year. While it is hard to estimate when this labor supply will be exhausted, some early signs suggest that incrementally higher wages are required to move workers to urban centers. This should chip away at productivity growth.

There are also signs that Chinese policymakers are focusing more on shoring up rural infrastructure. Following the food-price shortages of recent years, the government is promoting increased farm growth that will help stabilize prices and—as an unintended consequence—give rural workers less reason to migrate to cities. If that slows factory output, so be it. A further demonstration of the change in mind-set is the recent adoption of a new labor law that, among other things, sets a minimum wage ranging from anywhere between $60 and $110 a month based on the per capita income of each province.

China remains a great economic growth story and is on the path to converging with the industrialized world. But developments of the past year—from commodity-price-led inflation to the slight shift in the government's priorities—indicate that the pace of convergence is set to slow in the years ahead. The 11.9 percent growth rate recorded last year was probably the high-water mark of China's economic miracle; growth could slow to 8 percent or lower in 2009. While that will prompt stimulus measures from the government, it is unlikely that China's growth trajectory will return to the 10 percent-plus rate that it sustained with little inflation from 2003 to 2007. After all, when fixed investment has exceeded 40 percent of GDP for years, there's a limit to how many more new power plants and roads the government can help build.

The $3.5 trillion economy's potential growth rate is probably closer to 8 percent, a rate that hardly detracts from its reputation as an economic miracle. But the shift to a slower growth plane is likely to be painful for many economic agents—from property developers in China to commodity traders worldwide—for whom the idea that anything related to Chinese demand could be bid up to any price had been taken for granted. Although it is starting off as a cyclical downturn, the bigger story is that the law of economic gravity is catching up with China, too.

Sharma is head of global emerging markets at Morgan Stanley Investment Management.

© 2008