When the argument about “peak China” first emerged a few years ago, most scholars were quick to rebut the notion that China’s rise had reached a plateau. These observers dismissed the argument that China’s difficulties would prevent it from ever catching up with or overtaking the US.
They pointed to China’s many strengths such as its government’s long-term planning and resource mobilisation capacity, its growing technological prowess and its extraordinary economic competitiveness.
But, it has been a rough ride for the Chinese economy of late and the doubters are coming back. It has not helped that policy efforts to re-energise the sluggish economy have not been convincing to either financial markets or to China’s own consumers. The decline in China’s population is unfolding faster than expected and some see China struggling through a Japan-style deflationary trap for many years.
So, as we see another round of “peak China” arguments being put forward, is it right to be pessimistic about China’s rise? Our take is that China will indeed face some difficulties in the coming years and its economic growth is almost certainly likely to be a pale shadow of what it used to deliver.
But remember, this is a relative game: Other large economies such as the US, Europe and Japan will also slow as their populations age, productivity growth becomes harder to achieve and as they struggle with issues such as excessive public debt and under-funded social security obligations.
There could also be further realignments of currencies which could see the Chinese yuan appreciate against the US dollar.
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Given these factors, and with the very important proviso that China will make the right policy decisions, China’s share of the world economy could still overtake that of the US by 2050 — simply because a slower growing China will still expand faster than an also slowing US and other large economies.
The cyclical difficulties can be overcome
China’s slowdown is the product of both cyclical and structural forces. Looking first at the cyclical issues, we believe that the most likely scenario is that the real estate correction and deleveraging that are depressing economic growth can be eased for two reasons.
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One is that Chinese policymakers are slowly, if rather fitfully, edging towards the right measures needed.
China’s central bank, together with other state financial agencies, have committed credibly to providing the funding, reduced interest rates and regulatory changes needed to offset the depressing effects of the real estate correction. The follow-up on the fiscal side has been wanting, which is why financial markets fell sharply this week.
But our baseline view is that even here the advocates of greater fiscal support for the economy are gaining traction such that more fiscal spending will soon be evident.
The second is that the economy is adjusting itself to mitigate the damage from the contracting property market. The share of real estate activities in the economy as a whole has come down sharply in the past three years, almost halving from the near-30% of a few years ago.
Recent policy measures will help clear the inventory of excess housing in time and prices will find a bottom. In the meantime, other engines of growth — such as renewable energy, electric vehicles, batteries and other higher-technology products — are emerging and eventually will be large enough to drive higher-quality growth.
We are not lightly dismissing the risk of China suffering years of deflation as Japan had to. But the experience of Japan is fresh in the mind of China’s leaders. Moreover, there are tried-and-tested policies that can be used to prevent such a period of malaise — and the Chinese authorities appear to be realising this. Overall, we believe that China will stabilise its economy and place it on a decent foundation for future growth.
The long-term drivers behind China’s place in the world
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If the current economic headwinds can be sorted out within the next couple of years then the issue is whether, in the long term, China can grow faster than the world average in US dollar terms and so increase its share of world output. Thus, there are two elements in this story — China’s own growth relative to the world and to the US, and the trajectory of the Chinese yuan relative to the US dollar.
Can China grow faster than the world average over the next few decades? It will not be easy as China faces some fundamental challenges.
For one, the demographic decline seems to be happening in China at a much faster pace than in the US or Europe, perhaps a result of China’s harsh one-child policy that was pursued for too long.
Such a demographic decline is hard to reverse as countries as diverse as Japan, Singapore, South Korea and many European countries have discovered. So, we must assume that the demographic headwind will only get worse.
The United Nations forecasts that its population will decline by around 100 million to about 1.3 billion by 2050 and as low as 770 million in 2100, almost half the current population.
Another concern is China’s over-investment since the early 2000s.
Investment accounted for 45%–50% of GDP for decades, an unheard of feat that no other economy has ever sustained for so many years. The upshot was that China borrowed growth from the future — instead of spreading investment over many years, China telescoped the building of roads, railways, mass transit systems, housing and industrial capacity into a much shorter period of time.
That allowed China to enjoy a huge spike in growth. But now, with so much excess capacity evident in industry, housing and infrastructure, investment will have to slow, detracting from economic growth.
Then there is the global environment which is becoming less welcoming of China’s exports. We all know about the proliferation of trade restrictions that the US, Europe and Japan are placing on China’s exports for geo-strategic reasons. That factor can only get worse in coming years. But it is also emerging economies, many of whom are friendly to China, that are also restricting Chinese exports.
In recent months, countries such as Chile, Colombia, Brazil, Turkey, Thailand, Indonesia and South Africa have turned to restrictive trade practices in order to stem the surge of Chinese exports of items such as steel or light consumer goods.
China’s exports are so large and so price-competitive that local industries in many of these countries are overwhelmed, with damaging effects on employment and financial viability of firms which are politically untenable. China’s current export-oriented strategy has not taken full account of these challenges.
Given these hostile elements in its environment, what China needs is accelerated technological progress which can then generate the kind of productivity growth that can offset these formidable negatives. China’s productivity performance in recent years has been weak, with the declining contribution of what economists call “total factor productivity” or TFP.
TFP is an overall measure of how the economy brings together land, labour, capital and entrepreneurship to create value. Reversing the slow pace of TFP growth will require reforms in key areas. The good news is that this is beginning to happen.
After a period of hesitation, it looks like the authorities are edging towards structural reforms that are needed.
For example, recent high-level meetings of the political leadership have produced an agreement to move ahead with easing regulations that depress the livelihoods of the roughly 300 million migrant workers in urban areas. These workers are a huge source of consumer spending power which has been untapped because of restrictions on them in areas such as schooling, healthcare, ownership of homes and pensions.
Liberalisation here will help rebalance the economy towards a healthier mix of more consumer spending and less dependence on investment or exports. As their spending power is unleashed, it will also spur the development of higher value services, reducing China’s reliance on manufacturing as well.
It also appears likely that the allocation of tax revenues among central, provincial and local governments will become more balanced, providing the fiscal resources that local governments need to fulfil their many responsibilities. Other reforms — such as a bigger role for private firms and a wider social safety net — are long overdue and still pending but the recent commitment to tackle reforms suggest that these necessary policy changes will gradually be put in place.
Putting it all together, our model suggests that China can grow by an average of around 3% a year until 2050 even with the travails mentioned above.
During the same period, we estimate that the US will expand its economy by around half that pace while Europe also slows markedly. This will allow China to gradually increase its share of the world economy relative to America.
How will the yuan move against the US dollar?
Predicting long-term currency shifts is subject to a wide margin of error. Still, there are a few factors that argue in favour of the yuan rising in value against the USD. Remember that the USD has enjoyed a period of persistent and unusual strength. This has come about more because of the problems afflicting the USD’s rivals such as the euro and yen rather than because the USD’s fundamentals are themselves inherently strong.
Note that there are already signs that the USD has reached a peak with the euro and pound sterling strengthening until recently against the USD. Over time, we can see America’s rising and possibly unsustainable budget deficits as well as its high foreign debt and current account deficit leading to downward pressures on the currency.
Moreover, by weaponising the USD for political purposes such as to enforce sanctions on its rivals, the US has incentivised other economic powers including friends such as the Europeans to look for ways to diversify away from the USD. As other large economies develop their financial markets, the tendency of global savings to be so dominantly invested in USD assets is also likely to diminish.
Hence our view that the yuan will appreciate over time against the USD. As the yuan becomes more valuable, the USD value of Chinese economic output will rise, building on China’s better real growth performance to further increase China’s share of world GDP.
Conclusion
In essence, we are saying that China can muster growth that is higher than the global average over the next few decades — and that its currency could appreciate against the USD in that period. Even with the problems of an ageing population, hostile geopolitics and difficult export markets, it can still out-grow the large developed economies of the US and Europe which confront headwinds of their own.
The big assumption we are making is that China’s leaders will pursue reforms to rectify weaknesses in its economy. Without such reforms, China will not achieve the productivity growth needed to offset demographic decline and to keep strengthening its competitiveness. The other great assumption we are making is that China will avoid a military clash with the US that will set itself back.
These are reasonable assumptions to make. Thus, as we think about the future, it still makes sense to plan for a China that would be a dominant economic engine at least on par with the US and which will leverage off those strengths to project military and diplomatic power.
Manu Bhaskaran is CEO of Centennial Asia Advisors
