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The Problem With China

Feature Stories | Oct 06 2023

China is facing debt, deflation and demographic risks that threaten to derail its growth ambitions.

-China facing a 3D problem
-Monetary and fiscal stimulus critical
-Spillover into Asian economies
-Spillover into commodity exporters

By Greg Peel

China has made steady progress in its journey towards high-income status over the past decade, notes Morgan Stanley. It was on the cusp of reaching it in 2021, but renewed “3D” challenges (debt, demographics, and deflation), the regulatory reset on the private sector, and geopolitical tensions determine the last mile is bumpy. The rising risk of a debt-deflation loop has led to questions about whether China can avoid a middle-income trap.

With regard a “debt deflation loop”, central banks target a small amount of inflation, usually, 2-3%, which is not enough to cause a cost of living crisis if wages are rising as well, but enough to reduce the “real” value of debt over time. By the time you get to the end of your 25-year mortgage, for example, the real value of the original loan has diminished due to inflation and your income has risen to make servicing the debt easier over time.

If deflation, or negative inflation, takes hold, the real value of debt increases over time.

A “middle-income trap” is a situation in which a middle-income country can no longer compete internationally in labour-intensive industries because wages are relatively too high, but it also cannot compete in higher value-added activities on a broad enough scale because productivity is too low. Consequently, there are fewer avenues for further growth.

Factoring in increased secular headwinds, Morgan Stanley has revised down China's 2025-27 real GDP growth forecast to 3.6% per annum from 4.4% in 2023-24. The key drag is structurally lower foreign direct investment inflows and the lingering impact of regulatory reset on the private sector, weighing down productivity growth and labor quality contribution. Another factor is weaker capital input amid deleveraging in the property sector and local government financing vehicles.

To avoid the risk of a debt-deflation loop stemming from property sector and local government deleveraging, Morgan Stanley believes the key will be to stabilise aggregate demand and anchor inflation expectations with concerted fiscal and monetary easing, followed by reforms to sustain productivity. Timing and scale of implementation will be critical.

The broker’s bull case has Beijing achieving this in two to three years. But risk is skewed to the downside, with a bear case of prolonged deflation, and GDP growth down to 2.2% pa over 2025-27, ensuring a continued rise in debt to GDP and a middle income trap.

More than Just 3D

Morgan Stanley warns of China’s 3D risks of debt, demographics and deflation. ANZ Bank chief economist Richard Yetsenga lists debt, demographics and “destiny”.

The bottom line to destiny is that economies do not grow at a runaway pace forever. China’s GDP growth peaked at 15% in 2007. If that pace had been maintained, China’s economy would be growing exponentially and by now would have “gone parabolic”.

The reality is steady growth is still maintained at slowing growth rates. US growth in the 1950s was lower than the 1940s, the 1970s lower than the 1960s, and the 2000s lower than the 1990s, Yetsenga points out, but it’s still the world’s biggest economy.

Call it the “bigness” factor. In 2001, China accounted for 7.6% of world GDP. Last year, the figure was 18.5%. Accessing resources simply becomes more challenging on the scale required when economies get this big, Yetsenga notes. Export markets also become progressively less accessible as market share rises.

Demography is Destiny

The above heading is a somewhat hackneyed economic expression. But whereas Yetsenga speaks of debt, demography and destiny, the latter two are intertwined.

China’s population is shrinking due to the introduction of the one child policy in the 1970s. That effect has been compounded by a near-halving of the country’s birth rate during the pandemic.

MLC Asset Management’s chief investment officer Dan Farmer offers some statistics:

-Only 12 million babies were born in China in 2021, the fewest since the famine of 1961;

-Since 2010, China’s working-age population (16-59) has fallen by -40m workers to less than 900m today;

-China’s population grew by a net 480,000 in 2021, the lowest ever rate;

-A forecast from the Shanghai Academy of Social Sciences implies China’s population in 2100 will be less than half of what it is today.

Policy changes are unlikely to easily solve China’s demographic problem, Farmer warns. The easing of the one child policy to allow two children per couple in 2015 did not translate to an increase in births, and so it’s uncertain that increasing the limit to three children will have much impact.

China’s population has reached a level of education and income at which having larger families has lost its appeal. Increased participation of women in the workplace and changing attitudes toward marriage means people are less inclined to have children.

Additionally, the rising cost of living and changing expectations toward quality of life and lifestyles means Chinese people are less willing – and capable – of taking on childrearing responsibilities.

The latest catch-cry is “China is going to become old before it becomes rich”.

High debt, falling population and declining rates of economic growth are a highly problematic combination, notes Yetsenga. Debt requires growth to resolve, growth requires people and the people’s appetite to prioritise prudence will eventually rise as debt rises.

From less than 20% of GDP 15 years ago, China’s household debt has risen to 61% of GDP, close to Japan’s 68% and the US level of 74%.

The Good News

China’s rapid economic growth since 1980 has sucked the life out of growth potential in poorer countries. While the pandemic has brought China’s two decades of economic exceptionalism to a close, it is not all bad news, Yetsenga suggests.

Business and capital already have a wider field of vision. Foreign direct investment into China has fallen to its lowest level in modern times, while FDI flows to India reached a record in 2021 and are overtaking flows into ASEAN countries. India has seen net inflow of portfolio capital this year, while the rest of Asia has seen net outflows. Flows to China will likely recover as the economy stabilises in the short term, but the great capital reduction is in train.

The Bad News

China’s economic trajectory matters to the world and is especially significant for Australia, notes Farmer, as the prosperity of our natural resources companies, education providers, tourism industry, and wine producers, amongst many others, is bound to the country’s fortunes.

Last year, China accounted for 64% of US chipmaker Qualcomm’s sales, and 37% of Mercedes-Benz’s retail car sales.  A China that buys less from the world, or invests less globally, will be an economic handbrake.

As China came out of covid-related restrictions last year, there were expectations its economy would roar back to life. That’s not how things have panned out. Some parts of its economy did rebound, such as domestic tourism, hospitality, and retail services, on the release of pent-up demand, but soft durable goods consumption trends, weak private-sector investment rates, and households emphasising saving, suggest to Farmer people and companies are battening down the hatches.

The slowdown in China’s medium-term growth will spill over to the rest of the world, warns Morgan Stanley, via four channels: trade, commodity prices, multinational corporations’ operations in China, and financial conditions.

Using an input-output approach, the broker estimates each one percentage point decline in China's growth rate would reduce growth in other Asian economies by -15 basis points. East Asian economies such as Taiwan and Korea, with even closer trade links, would face greater pressure on growth, though there will be some offset from weaker commodity prices.

Larger economies like India, Indonesia, and Japan have idiosyncratic factors which allow them to generate their own domestic demand, which will act as an offset.

Australia also stands out, notes Morgan Stanley, given its exports of iron ore, which are highly exposed to China's property and infrastructure sectors. Other commodity exporters like Indonesia and Malaysia are less affected on a relative basis, as they mostly export energy and food to China.

China's nominal GDP growth would decelerate even more sharply and in turn weigh on regional nominal GDP growth, particularly in economies with high debt levels and weakening demographics, such as Hong Kong, Japan, Korea, Singapore, Taiwan, and Thailand.

Despite China's large role in the world economy, Oxford Economics estimates the global spillovers from a severe slowdown would likely be moderate. Oxford’s modelling suggests a -4% drop in Chinese GDP by 2026 relative to baseline would cut G7 GDP by only -0.2%, though the economists agree the impact on neighbouring Asian economies would be bigger.

The impact of a weaker China is mostly felt via real economy channels as its global financial links are relatively modest, Oxford notes. The biggest hits are to economies with deep trade links to China, followed by exporters of China-sensitive commodities.

The GDPs of South Korea, Taiwan, and Vietnam are reduced by around -1% compared to the economists’ baseline. Commodity exporters see GDP falls of around -0.5%.

For the US, GDP is reduced by just -0.1% relative to baseline by 2026. This is because the US has the lowest trade exposure to China as a share of GDP of the G7 economies, a neutral exposure via commodities, and relatively modest financial links, Oxford suggests.

Oxford Economics does assume any fiscal policy response in China in its scenario. But it does estimate that fully offsetting the short-term downturn by fiscal measures would increase total government debt to 145% of GDP, which is above most advanced economies and would make China one of the most indebted emerging markets.

Food for thought. And we haven’t even mentioned geopolitics.

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