China – Making Sense of the Country’s Current Challenges
China’s economy almost single-handedly helped to backstop the global economy in the years following the global financial crisis. However, with its growth losing momentum recently, and the country also facing a host of other challenges, not least the escalating trade tensions with the US and the need to transition away from a debt-fuelled growth model, it too is now finding the going increasingly difficult. Against such a backdrop, the country’s policymakers are confronted with a difficult set of challenges to which this report will primarily be focused. It will also seek to answer the question of why the loss of growth momentum in China matters to rest of the world, as well as what policymakers in the country are doing to address some of the key challenges that it faces.
Context – A slowing domestic economy…
China’s economy has been slowing in recent years – and not just due to cyclical factors – but structural ones as well. Reflecting this, it’s now running at or close to 6.5% annually. While this still represents a pretty buoyant pace of growth compared with anything seen in the developed world, the point to note is that it’s well short of the double-digit growth the country was often able to achieve for some 20 years or more (see Chart 1) – a period during which it was able to boost its income per capita over eight-fold to its current level beyond US$8,000. Although unprecedented, this breakneck pace of growth over the past couple of decades was in part a reflection of China’s low starting base and the catch-up process that it underwent as it transitioned from being a more agricultural-based economy towards an industrialized one. With this in mind, both market and policymakers’ expectations of the Chinese economy going forward have accordingly been adjusted downwards recently with, for example, the Chinese authorities themselves now targeting a growth figure of 6.5% for this year as opposed to 6.5-7% which they considered to be the norm in recent years.
Aside from the structural factors alluded to above, a look at more timely data reveals that the Chinese economy is also undergoing a cyclical slowdown. This is clear to see from leading high-frequency indicators, including industrial production and retail sales, both of which have continued to exhibit a softening bias (see Chart 2). Additionally, this is also corroborated by the weak tone of the country’s PMI data, though it’s worth noting here that the fortunes of the services sector of the economy have fared somewhat better than that of the manufacturing sector (see Chart 3).
Draws attention to the underlying factors behind China’s slowdown…
The recent slowdown of the Chinese economy is not exactly new news. But, that said, the reasons behind this slowdown are not all that well understood. While most of the focus has inevitably been on short-term factors, such as the escalating US/China trade dispute and the deleveraging campaign the Chinese authorities embarked upon to mitigate risks to the economy from the build-up of excessive debt, these are by no means the only factors that are at play here. In fact, long-term structural factors of the sort outlined below have also been of key importance to the recent slowdown of the Chinese economy:
Demographic changes
As a result of its one-child policy, China is facing a rapid deterioration in its demographic profile. The ratio of old people to young workers is forecast to rise sharply. Indeed, the worry is that China could follow the way of Japan, its more developed Asian peer.
In the 1980s, Japan was often predicted to become the world’s largest economy. However, the Japanese economic miracle came to an abrupt end following the 1990s. One reason was a shift in demographics and a decline in the percentage of young working adults. While China still has a healthy percentage of working age, the ratio of young people to elderly will fall significantly, limiting opportunities for economic growth.
Excessive debt accumulation
Before the onset of the global financial crisis, Chinese gross debt stood slightly north of 150% of GDP. But by 2017 this figure topped 300% of GDP. Such a rapid pace of debt accumulation has been unprecedented and, if left unchecked, could sow the seeds of a financial crisis in China.
That said, there are several China-specific factors – high savings, current account surplus, the small external debt – which can help mitigate the near-rem risk of a disruptive adjustment. However, despite these factors working in China’s favor, the growth in its debt is starting to expose its vulnerability. Further complicating the picture is the rise of local government finance vehicles (LGFVs) which are, in essence, special purpose vehicles set up to by-pass federal government restrictions on local governments ability to borrow in the capital markets. Additionally, it’s also worth adding here that it’s not just the growth of debt which is a problem but also its declining effectiveness in stimulating the economy. Indeed, evidence from the likes of the IMF suggests that each incremental unit of debt is adding less to the country’s overall growth.
High investment levels not sustainable
One feature of Chinese economic growth is that it’s based on very high levels of investment (>40% of GDP). While this is facilitated by the country’s relatively high savings rate (see Chart 6), such a high level of investment is unsustainable and certainly well above the levels which prevail in other BRIC economies.
One issue of relying on investment to promote economic growth is that it has become increasingly difficult to find suitable investment projects. There is a diminishing marginal utility of extra investment, especially as the economy and housing market mature. To continue its economic development, China will need to further encourage its rebalancing efforts towards higher consumption.
Less room for catch-up than in the past
Very high rates of growth are possible when there is room to “catch-up”. But as China has progressed from being a low to the middle-income country over the course of the past couple of decades, the gains from this catch-up process are becoming harder to come by. Illustrative of this dynamic is the country’s urbanization rate which has more than doubled from 26% in 1990 to 58% as of 2017. While it is envisaged that progress on this front is perhaps set to run further as the country converges towards levels seen in high-income countries (82%), it will likely be slower than in the past and, as such, the overall benefits to the Chinese economy will be more tempered.
And raises concerns not just for the domestic but world economy as well
The current challenges facing the Chinese economy matter a great deal more now than they would have some 10 or 20 years ago. At the turn of the century, China accounted for some 7% of global economic activity, while the equivalent figure today stands within the vicinity of 20%. In fact, the rapid pace of growth over the past couple of decades has propelled China to second place in the league table of the world’s biggest economies.
Perhaps the most obvious area where a slowing Chinese economy has made its presence felt is on the commodity markets. Indeed, China accounts for around half of all the world’s steel, copper, coal, and cement consumption. With this in mind, the country’s slowdown has had a negative bearing on a wide range of commodity groups, not least base metals, and crude oil.
Elsewhere, it’s also worth noting that with a slowing Chinese economy and its ongoing trade dispute with the US still continuing to play out, global trade growth has decelerated rather sharply. As such, this has adversely affected the prospects for the global economy and, within this, those economies that are particularly open to international trade. A key example of this is Germany which, while it has thus far avoided a technical recession, has seen its economy ground to a halt as demand from the likes of China for the high-end manufacturing gear that it produces has fallen dramatically over the past year or so.
At a more granular level, a slowing Chinese economy has had negative spill-over effects on the corporate sector – and not just those within China itself but also at the global level. Indeed, it has dampened earnings growth among leading US-based and other global companies, including Apple, and reflects the growing importance of the Chinese market to such companies as a source of earnings.
Policy response/concluding thoughts
The slowdown of the Chinese economy has not gone unnoticed on the part of its policymakers. Indeed, they have sought to prop it up through a combination of both monetary and fiscal policy. On the monetary policy front, they have mainly resorted to reserving requirement ratio cuts, as well through the injection of liquidity to the country’s banking system so that a “credit crunch” scenario is avoided. On the fiscal side, the authorities have cut VAT with a view to stimulating both corporate and consumer spending. Taken together, these measures have helped to stabilize growth at above the politically sensitive level of around 6%. That said, with growth once again taking precedence, the recent deleveraging campaign and drive to rebalance the economy towards the consumer sector appears to have suffered a setback, suggesting that while policymakers are aware of the underlying challenges facing the Chinese economy their ability to enact the necessary reforms remains at best limited.
Source from: MERatings