There is plenty of talk these days about a serious slowdown in China that is a precursor of a huge crash that will take the world economy down with it. The general story is that China’s economy is dysfunctional because of extensive state intervention, bubbles, and dependence on exports. We look at this claim point by point to get a clearer picture of what lies ahead for this rising giant. Let’s go!
Is it true and is it a problem?
It is true that many corporations in China are state-owned directly or indirectly. Is this a problem? Short story: it can be! SOEs eventually lead to distortions: direct subsidies, easy financing, implicit or explicit credit backing, protection from international competition in all sorts of ways, and more.
When this is widespread, it reduces incentives for efficiency and stifles the private sector which doesn’t have all that government help, and the entire corporate sector can start looking like a zombie that is sucking the life out of the economy.
China’s largest corporations are all state owned and a non-negligible proportion of China’s enterprises are state owned. The major ones are in banking, oil, and construction.
Export growth may be maxed out
Since the 1990s, China has been heavily relying on exports to industrialized countries to fuel growth and job creation. This was accomplished through various policies: export-oriented government subsidies, tax and regulatory incentives for multinationals to produce in China, currency manipulation to keep the currency weak and make Chinese goods cheap for other countries, capital controls, and other interventions.
This has worked. It created rapid industrialization, as well as technology and human capital transfer from multinationals of industrialized countries that produced in China, thus creating jobs and income, as well as causing a global supply shock in world markets, which helped keep global inflation and interest rates a bit lower than they otherwise would have been*.
*Note: I verified this myself in a Bank of Canada research note and it seems that “the China effect” caused core inflation to be 0,3 percentage points lower than it otherwise would have been through a combination of direct effect (lower import prices) and indirect effects (more competition for domestic producers and workers, thus keeping wages and prices in check). Global savings also increased due to Asian savings flocking to global markets in the increasingly interconnected global market, driving interest rates down worldwide as well.
Chinese farmers came to the “formal labor market” and average productivity increased due to textbook gains from specialization and productivity on “catch-up effects” (when you start from a low-performance point, it is easy to improve).
The problem is that you can’t rely on export growth and catch-up forever (for reasons I don’t want to get into here). The share of household consumption to GDP in China has dropped from 60% in 2000 to 48% now, while real wages have increased at a steady pace. Higher wages, high growth, and lower relative consumption means that there was more and more savings, and those savings were looking for returns. Since there are capital controls that make it hard for Chinese residents to send their funds in foreign markets, all that money went to stocks and housing, causing potential bubbles. See the problem? Chinese officials see it too!
The post-2008 China
The 2008-2009 global shock has exacerbated structural undercurrents. First, the oil price drop hit big oil SOEs hard, which hit the stock market in 2015 and 2016. Second, the objective of Chinese officials to retreat from many SOEs and only focus on a few “strategic” ones while reforming and privatizing created fears of lower profits in the short run while the process unfolds. This is probably warranted, as the “transition process” will indeed probably hurt many SOEs and stocks in the short run. Third, there is huge difficulty regarding data availability and reliability for China, which only adds to uncertainty. Fourth, there is a major structural demographic undercurrent in all this, and it is the elephant in the room. Keep reading…
Does this mean the entire economy is “going down” and the system failed? No. There is still a majority of private sector activity, demand-oriented production, and technology adoption, and the “catch-up effects” will be felt for some time.
As policies gradually change to allow more freedom in capital movements, domestic markets may marginally get less capital, which could weigh on stocks in the long run. It is hard to imagine more savings (capital) in proportion to GDP for China, as it is already stratospheric and considerably higher than almost all countries of the world, including Japan and Germany.
The only realistic direction going forward is more consumption and/or more taxes and government services, which is really “indirect consumption” of households done by the state, without freedom of choice.
It’s a structural story
The headwinds that China faces are structural long term challenges. The stock market will probably be volatile and risky due to the policy changes to come and the transition towards less exports (if that ever happens), but the main issues within China are all structural by nature: demographics, capital controls, excessively high savings, too much state in the wrong places and not enough state in other places, and the inherent issues of emerging economies, such as little respect of property rights and corruption.
Demographics for China is a major challenge: the working age population has begun to shrink a few years ago, and since it is a structural demographic shift, it will continue going down for the next 20 years at least! This is the case for most rich countries as well. If you think this is a big issue, you are right, it is! Demographic tides are the single most powerful force that influence broad trends. Parts of the world that don’t have this “downward demographic shift” are India, Africa, and Latin America (business people and smart forex and finance people take note!).
Sorry for the doom lovers who feed on drama and “end of world” scenarios: it won’t happen. There are no big bubbles that are waiting to explode in China. This is hard for Westerners who spend every dollar to understand, but Chinese households save a LOT and have considerable equity in their houses. The localized housing oversupply in some markets will be purged over the next year in housing and does not pose any big systemic threat. You won’t find much “subprime” underwater mortgages in China, there is plenty of capital cushion in banks and mortgage equity for households to absorb a potential shock, and other markets are not at bubbles levels like has been seen in the past in the US or Japan.
However, the demographics imply weaker average growth going forward relative to the pre-2008 period. Does this automatically imply lower stock market returns? In a long run perspective, it would be the case, yes. But for emerging markets it is a bit more complex, because the downward trend caused by demographics could be more-than-offset by industrialization, higher wages, and higher corporate sales caused by household consumption and new opportunities brought on by policy changes.
Will immigration, increasing the retirement age, and the dropping of the one child policy change the picture? No. It will only help at the margin. The tide is way too big.
Is China 2016 Japan 1990?
On the demographic and “export orientation”, China looks a lot like Japan of the late 1980s. But Japan was more advanced in its industrialization, it is an island, and has roughly 10 times less population. So the comparison is hard to make. A lot depends on policies going forward, and that is why “China policy watch” needs to be a priority for all finance and business people. We will make an effort to help on this here at YourPersonalEconomist.com.
Is China 2016 Russia 1990?
No! While the move towards a decentralized market system happened “overnight” in Russia, causing lots of devastation, market and institutional failure, huge volatility, and a “privileged and connected take all” capitalism, the move to a market system in China has been implemented gradually, in a step-by-step way, with a recent crackdown on corruption, and this will continue. That is good. It means there is low probability of overnight “shock and awe” changes, because policy makers in China are qualified, strategic, and patient.
The demographics are clearly a cause for concern for long run trends in China. Is there a massive bubble in housing and stocks? The data is so unreliable that any call is essentially guesswork. My “guess” is that there are local bubbles, but no major systemic bubble, and the entire “system” is not threatened. The sources of risk for China are covered in the totally free 2-year outlook report on the website.
I hope you enjoyed this post and that things are a bit clearer now! Feel free to comment, share, and to contact me. Cheers!