China is aging but has some space to mitigate its impact

China’s population has kept aging rapidly over the past three decades but its impact on growth has so far not been very noticeable thanks to still positive population growth and the sustained path of urbanization. However, both two positive factors have moderated, which means that labor supply is no longer growing positively.

The primary concern is the further decline in the labor force participation rate. The trend could be partly offset by raising the compulsory retirement age. Also, the use of high technology may also ease the bottlenecks for the elderly to continue to be part of the labor force. Still, these measures are difficult to completely reverse the decelerating growth trend of labor supply.

Against the backdrop, the long-term solution for China amid population aging is to reduce its reliance on labor force by increasing the use of capital in production. Interestingly, while China had for long experienced higher growth rate in the relatively more capital-intensive sectors than the labor-intensive ones, this was not the case after mid-2018. Another very important factor is expenditure on research and development (R&D) and human capital which could increase total factor productivity. China has raised its expenditure in R&D and the enrollment in tertiary education has ballooned. However, such efforts have not yet turned into a further rise in total factor productivity growth rate. China will need such lift to mitigate the effects of structural deceleration coming from an aging society. 

Fiscal pressure from rising pension and health expenditure also constitutes a drag for the economy. Over the past years, China’s official social security balance has been partly supported by internal transfers from the general public balance, but the latter is also expected to be under pressure given fast growing public debt. Moreover, as China becomes a more developed income economy, its healthcare system is expected to improve with a potential ballooning effect on costs. That said, China still has high saving rate to finance growing debt service from public debt.

All in all, although population aging has become an important aspect when analyzing China’s structural deceleration, one needs to disentangle its direct impact, namely that through the labor input which is obviously negative but limited in size, with the indirect one. The indirect impact, namely whether the reduction in the labor brings about lower productivity, is much more important. So far China’s recent experience does not bode well as productivity has been coming down together with the labor force decline. China will need to return to more capital-intensive economic activities, with robots being the best example of the way to go. China is also expected to increase its welfare expenditure which could exacerbate its fiscal condition, which affects its long-term growth potential. The sustainability of China's public finance, however, depends on nominal growth rate, which will continue to be higher than in developed economies with similar levels of debt.

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