We believe China has entered a phase of declining trend growth, which is neither good nor bad news; it is an inevitable reality. Slowing trend growth should not come as a surprise, because all countries, as they develop and as their per capita GDP rises, experience a loss in the pace of headline economic growth. First, the lowest-hanging fruits have been picked, and it will be more difficult for a large and wealthier economy to generate high percentage growth year-after-year. Further, one of the key reasons behind China’s lower potential growth rate will be demographics. Another matter is its growth model that has, in the past decade, relied on rapid debt accumulation. This growth model needs to be replaced with something more sustainable. The following points explore several issues related to China’s structural growth rate, and draw conclusions on how investors should monitor China from now on.
- China’s demographic trend is around 15-20 years behind that of Japan. China’s workforce has just peaked and will likely decline from here.
- Despite this demographic headwind, just as Abenomics has yielded some success in boosting the workforce to counter the demographic trend, there are ways that China could delay and slow down these hostile trends. China won’t be able to reverse the ageing trend, though.
- Unlike Japan or Europe, China is getting old before it is rich; China will face the challenge of sorting out its pension finances. One possible trump card is for China to utilise the shareholdings of the SOEs: the market cap of China’s SOEs is around 198% of GDP, or USD26 trillion1, and these state-owned assets could be put to good use to deal with China’s huge pension demands.
- Part of the tendency for the growth deceleration since 2008 was structural in nature but had been misread by Beijing to be the cyclical consequences of the GFC in 2008. Unconditional Keynesian stimuluses were imparted to support economic growth, causing China’s economic future to be laden with a huge overhang of debt. Beijing has now recognised that this policy was erroneous. This means that economic growth in the past decade was artificial and flattered, and Beijing is willing to accept lower economic growth in exchange for higher quality growth.
- With the demographic headwind that China will confront in the years and decades ahead, and an official recognition that Keynesian stimulus to counter this tend were counter-productive, China will likely exhibit several familiar macroeconomic features: a declining potential growth rate; stable natural interest rates (low bond yields); and declining aggregate savings (inferior external balance). The good news is that the policy makers in China today are already contemplating the policies that are needed to cope with these structural challenges. Such a shift in policy focus from short-term to long-term should, in our view, keep China on the path to prosperity. Investors, therefore, should expect China to be allowed to enter into a phase of declining trend growth. As the ping pong ball falls down the stairs, there will be (noisy) bounces along the way, but the overall trend will be down. Growth, however, will be of higher quality and therefore be more sustainable.
The bottom line
In the old Greek thought experiment the ‘Ship of Theseus’, a ship that goes out to sea for an extended journey would carry spare timber to repair the ship from time to time. The question arises that, over time, if the entire ship is replaced with new timber, would this still be considered the same ship? I think this is a good analogy for China. The Chinese economy is such a ship that derives its economic growth and development through reforms (replacing and transforming parts of the ship at rates that are much more rapid than most other ships). The reliance on Keynesian stimulus in the past decade was an aberration in Chinese policies, not the norm. How fast and sustainable China’s ‘Ship of Theseus’ can be in the years ahead will be determined by its structural reforms, in our view. In this note, we made the point that China’s potential growth will gradually decelerate, in any case, but will likely be of higher quality with fewer imbalances.
The above article is an extract from our research paper “China’s Decelerating Potential Growth and Theseus’ Ship” published on April 29, 2019.
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