Martin Wolf: Why China’s economy might topple

April 2, 2013 6:42 pm

Why China’s economy might topple

By Martin Wolf

As Japan has shown, shifting to a lower-growth model is risky

Over the next decade, China’s growth will slow, probably sharply. That is not the view of malevolent outsiders. It is the view of the Chinese government. The question is whether it will do so smoothly or abruptly. On the answer depends not only China’s own future, but also that of much of the world.

Official Chinese thinking was on display at last month’s China Development Forum, organised by the Development Research Center of the State Council (DRC), which brought influential foreigners together with high-level officials. Among the background papers was one prepared by economists at the DRC, entitled “Ten-year Outlook: Decline of Potential Growth Rate and Start of a New Phase of Growth”. Its proposition is that China’s growth will slow from more than 10 per cent a year from 2000 to 2010 to 6.5 per cent between 2018 and 2022. Such a decline, notes the paper, is consistent with the slowdown since the second quarter of 2010 (see chart).

The authors note two possible reasons for the decline: either China has fallen into the “middle income trap” of aborted industrialisation; or it is managing the “natural landing” that occurs when an economy begins to catch up with advanced economies. This latter scenario played out in Japan in the 1970s and South Korea in the 1990s. The DRC paper argues that, after 35 years of 10 per cent growth, it is at last happening to China.

Here are a few reasons why the authors say this view is plausible. First, the potential for infrastructure investment has “contracted conspicuously”, with its share in fixed asset investment down from 30 per cent to 20 per cent over the past decade. Second, returns on assets have fallen and overcapacity has soared. The “incremental capital output ratio” – a measure of the growth generated by a given level of investment – reached 4.6 in 2011, the highest since 1992. China is getting less growth bang for its investment buck. Third, growth of the labour supply has fallen sharply. Fourth, urbanisation is still rising, but at a decelerating rate. Finally, risks are growing in the finance of local governments and real estate.

This melange of reasons is enough, argue the authors, to indicate that a transition to slower growth has begun. To analyse prospects more rigorously, the authors employ an economic model. Its most striking result is that long-established trends reverse. Fixed investment rose to 49 per cent of GDP in 2011. But this is forecast to fall to 42 per cent in 2022. Meanwhile, the share of consumption in GDP is forecast to rise from 48 to per cent to 56 per cent in 2022. Again, the share of industry is forecast to decline from 45 per cent of GDP to 40 per cent, while the share of services is to jump from 45 per cent to 55 per cent. The economy is consumption-led, instead of investment-led. On the supply side, the principal driver of the decline in growth is the collapse in the growth of the capital stock, as investment growth falls. (See charts.)

The view that such a growth slowdown is imminent is quite plausible. But one can advance a more optimistic view. According to the Conference Board’s data, China’s GDP per head (at purchasing power parity) is the same as Japan’s in 1966 and South Korea’s in 1988. These countries then had between seven and nine years of superfast growth ahead, respectively. Relative to US levels (another measure of catch-up potential), China is where Japan was in 1950 and South Korea in 1982. That suggests yet more growth potential. China’s GDP per head is just over a fifth of US levels. It seems to have much further to go.

However, there is also a case against this optimistic view. China is an order of magnitude bigger even than Japan. Its opportunities, particularly in the world economy, must be relatively smaller. Furthermore, as former premier Wen Jiabao often stated, growth has been “unbalanced, unco-ordinated and unsustainable”. This is true, on a number of dimensions. But the most significant is the dependence on investment, not just as a source of extra capacity, but as a source of demand. Consistently rising investment rates are not sustainable, since the returns ultimately depend on additional consumption.

This is where a far more pessimistic view emerges. As the experience of Japan has shown, managing a shift from a high-investment, high-growth economy to a lower-investment, lower-growth economy is very tricky. I can envisage at least three risks.

First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.

Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.

Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.

The government’s plan is, of course, to make the transition to a better balanced and slower-growing economy smoothly. This is far from impossible. The government has all the levers it needs. Moreover, the economy continues to have much potential. But managing a decline in the growth rate without an investment collapse and financial disruption is far trickier than any general equilibrium model suggests.

It is easy to think of economies that long showed superlative performance but failed to manage the inevitable slowdown. Japan is an example. China can avoid that fate, partly because it still has so much growth potential. But the chances of accidents are high. I would not expect one to stop China’s rise altogether. But the decade to come could be far bumpier than the last.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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