For China to maintain its growth trajectory, it will have to either rely on broad structural reforms or continue to depend on its current export surplus model. The former requires broad institutional reforms, while the latter has the potential to worsen geopolitical tensions. Either way, the path that China chooses for its future growth will have profound implications not just for investors but also for international relations.
This piece is the second of a three-part series on China that will explore the country’s property sector, GDP growth conundrum and external challenges.
In our recent commentary on China’s property sector, we dismissed worries about an impending financial crisis or systemic event. In contrast, we expressed confidence in a continued steady economic expansion for China over the coming quarters as a mix of policy stimulus and specific regulatory changes for the property sector helped to stabilize growth.
However, this near-term confidence is tempered by a realization that the Chinese growth model that powered the country’s rise over the past 40 years increasingly looks unviable. Unless the government embarks on broad-ranging structural reforms, China’s growth rate potential will likely continue to decline, possibly levelling off well below 4% annually.
Neither the source of Chinese success nor the path of its future growth is a great secret. In many ways, China followed an existing template of economic transformation that mirrored the success of other East Asian countries, notably, Japan, Korea and Taiwan. This prescribed a policy framework that sought to leverage a vast supply of cheap labor by creating an attractive destination for manufacturing. The Chinese state was responsible for helping to fund the infrastructure that supported the country’s manufacturing competitiveness. Clustered around major urban areas with good transit links, employment opportunities pulled in mass labor from the countryside and propelled rapid urbanization.
Together with a managed exchange rate and controlled capital account policy, savings were disproportionately channeled into domestic real estate while household purchasing power grew more slowly than headline nominal growth. This had the effect of amplifying real estate-related activities as a major economic driver, in addition to manufacturing exports and infrastructure investment (designed to facilitate the former).
The growth path that China has been following is very much in line with the experience of other East Asian nations. The difference is that China has pursued this course longer than its regional neighbors, thereby generating larger internal imbalances for longer. This has also meant that ultimate levels of credit expansion have been higher than its peers.
Figure 1 illustrates the comparison by attempting to harmonize the share of investment in the economy relative to China’s real GDP per capita levels. Both Japan and Korea’s share peaked near 40% and then levelled off in the 30%-35% range for the subsequent two decades. In contrast, China has peaked at higher levels and has also remained elevated for longer.
There are two questions arising from the scenario described above. First, why has China not followed the path of its peers? And second, what are the consequences of its current position for its future economic trajectory? The answers to both are interrelated. In Japan, corporate and bank balance sheets had to recognize credit losses, and the country’s main trading partner, the United States, had helped to force an appreciation in currency. Together, these factors brought a rapid halt to credit growth and lowered investment’s share of Japan’s economic growth. No other growth driver replaced it and low growth and deflation ensued for several decades, a transformation popularly known as Japanification.
China’s particular domestic governance and international relations have thus far precluded such an outcome, yet the challenge remains the same. Excess infrastructure investment has created industrial overcapacity with little room for productivity enhancing investments. Worse, the property sector is largely saturated and urbanization rates are approaching East Asian norms. This implies property and construction investment will remain constrained and investment will inevitably drop.
This means, for maintaining China’s growth trajectory, either higher consumption and/or higher net exports are required. Enabling higher consumption is indeed possible, but requires substantial structural reforms, focused around incentivizing lower household savings by way of expanded public services. The big structural reforms include the buildout of a more generous pension system, wider provision of public health services of reasonable quality, a re-design of public finances (especially central versus local government financing) and more flexibility in the hukou (resident registration) system.
They all require an overhaul of China’s institutional setup that would transform the country’s political economy, creating new constituencies of winners and losers.
Absent such reforms, the country will need to continue to rely on large export surpluses. However, China’s current size should mean the external implications of this reliance on export surpluses will be profoundly different from that of other East Asian regions. For instance, Taiwan has been generating the largest current account surpluses as a share of GDP for longer than the rest, but its export mix (not directly competing with native industries in developed economies) and the relative size of its export surplus mean the economic burden on the rest of the world has been light.
On the other hand, China’s geopolitical dimension is completely different. The country’s additional strain is not only about pivoting away from investment but doing so in an environment where its large current account surplus exacerbates geopolitical tensions. This makes the urgency for structural reforms greater.
China’s current growth trajectory will have profound implications for its bond yields, currency and equity markets. If China’s trend growth and inflation were to continue to drop, its bond yields are likely to continue to decline. Similarly, the yuan is likely to remain weak on the back of yield differentials and return seeking investments other than domestic real estate. As far as Chinese equities are concerned, they should showcase mixed performance with winners likely to emerge from policy-backed industrial and energy technology companies.