The Emergence of a Low Growth China
According to the IMF, the Chinese economy contracted 6.8% in the first quarter of this year. Most analysts expect modest recovery in the second half of the year, with an anticipated 2020 full year growth rate of 0.5% to 2%, depending on the course of the virus, among other factors. Most forecasts by China watchers for 2021 foresee a relatively strong recovery, generally between 6% and 8%.
Analysts believe that expected strong growth in 2021 will be driven primarily by infrastructure spending, through an already adopted stimulus package, and perhaps extra stimulus to be adopted next year. Similarly, in 2020, particularly in May and June, China’s recovery was primarily driven by infrastructure spending and not by consumer spending or exports. Essentially, after a precipitous drop in infrastructure spending in the first four months of 2020 China opened the taps in May and June, focusing especially on the usual suspect, real estate investment.
Although it is government stimulus and neither consumer spending nor exports that have buoyed China’ s economy, the Chinese government’s stimulus effort in the current crisis is a much more modest effort than the approach it took after the 2008 financial crisis. According to the IMF’s FIscal Tracker, the Chinese stimulus package announced in late May amounted to approximately 6.1% of GDP and focused on building renovation and upkeep, particularly residential, light rail, and communications, energy and water resources. The package is somewhat less reliant than the big infrastructure packages of the past that emphasized roads, bridges, tunnels, ports and airports — but it is still primarily an infrastructure package. It does not foster or herald a shift to consumer spending. Moreover, the Chinese stimulus effort is much smaller than comparable efforts by the EU, Japan and the United States.
The Chinese stimulus package is so much more restrained than its past effort because previous efforts after the 2008 crisis significantly worsened China’s portfolio of underperforming debt bringing China closer to either long term stagnation or even to a “Minsky” moment when capital flows rapidly out of investments with poor prospects, exerting downward pressure on asset prices, which in turn triggers greater capital flight, which in turn generates more downward pressure on asset prices which again causes greater capital flight, etc, etc.
With less room to maneuver China chose a more modest package, and aggregate two year growth rates for the Chinese economy for 2020 and 2021 are likely to be much lower than nearly double digit economic growth that followed the 2008 financial crisis and lasted for nearly 4 years. Aggregate average growth for 2020–21 is likely to be less than half the rates that emerged in the two years after 2008.
The Potential Dawning of Economic Stagnation
Debt levels can be a deceptive economic indicator. High growth countries often have high debt loads, but countries with stocks of unproductive debt vs. those with stocks of productive debt. are very different. The latter will produce a formidable income stream to help pay the debt; the former, not so much. So for the high debt country with unproductive debt its fiscal situation will tend to worsen over time, while for the country with productive debt, its income stream can lower its debt load, if needed.
Unproductive debt creates pressure for the withdrawal of capital, eventually provoking either long terms stagnation, the most famous recent example is Japan’s “lost decade” or the “Minsky Moment” of capital flight and asset price crashes. The closer a country comes to this moment the more conservative it will be about adding debt — at least if it is savvy about the potential for financial crisis
China’s very high and not completely defined debt level (thought by many analysts to be 350% to 400% of GDP from all sources), combined with the low productivity of this debt, places it uncomfortably close to long term stagnation or even to the forced deleveraging Minsky moment. The Chinese government’s strong grip on its economy and the strong belief among investors that it will bail out investors to prevent a massive asset price crashes probably makes long term stagnation the more likely outcome than the “Minsky” moment collapse — but either are possible.
The coronavirus and the ensuing world economic slowdown, combined with the US-China trade war, and the very high but largely unproductive debt burden China accrued after the 2008 financial crisis, have all brought this stagnation potential closer.
How Full in China’s Consumer Debt Sponge?
As China’s capacity to stimulate its economy with very high levels of capital spending, or through exports, begins to falter, what will take its place? What will sustain Chinese growth and help it to avoid either long term stagnation or an asset price collapse? The traditional answer has been increased demand from the Chinese consumer who account for a far lower share of national demand in China than in the United States or Western Europe.
But shifting national production from very high but unproductive levels of investment to much higher levels of consumer consumption is a fraught process that likely involves building up consumer services and shutting down production capacity in manufacturing and infrastructure — a process with very high switching costs. Inevitably, it creates many new economic winners and many new losers shifting the balance of power in a society often in unpredictable ways — anathema to China’s current rulers.
Even in in the best of times, with high growth rates, this process takes time and at least in the short term, lowers growth rates because of the many switching costs involved. Shutting down steel mills is costly; workers trained for a lifetime in steel production lose much of their value, and the healthcare, child care or entertainment sectors workers who may take their place have yet to be trained and deployed.
Without a very strong government role that forcefully takes away money and power from the manufacturing and investment sector and hands it to the consumer services sector, the outlook for shifting China’s vast productive capacity to better serve its own consumers is not reassuring. The Chinese consumer is supposed to be the sponge that absorbs vast amounts of Chinese production diverted away from exports and from capital expenditure. However, the Chinese consumer debt sponge is just as full as the American or European one.
The USA and Europe, on the other hand, have other sponges that have not absorbed much investment for many years and are more or less begging for more water. The USA and the EU both have neglected infrastructure spending. Also, corporations in the Western world have systematically under-invested for many years. If consumer demand falters, overall demand might be rekindled by government and corporate investment. The weaknesses of the government balance sheets is offset to at least some degree by the relative strength of the corporate balance sheet.
However, China does not really have this option, as much of their investment in infrastructure is wasted spending, and a good percentage of corporate investment is diverted into state-directed companies and military/strategic related expenditure with a low rate of return.
Declining Productivity in China
The Brookings Institution, citing World Bank data, notes that China’s total factor productivity has fallen significantly since the 2008 financial crisis, dropping from a mean of 3.5% annual growth in the three decades prior to 2008 to only 1.5% in the decade after.
TFP growth fell from 3.5 percent in the three decades up to 2008 to just 1.5 percent in the decade since (Figure 1).
The World Bank study further found that productivity in China suffered in multiple ways, both the level of productivity growth within specific industries falling and the trend in the allocation of capital among industries by the level or productivity suffering, as flows of capital to less productive industries increased faster than flows to those with greater productivity. Moreover, as might be expected, the role of productivity in increasing economic output decreased while the role of quantity of inputs increased. In other words, to produce a given amount of output in China the role of quantity of inputs rose relative to the role of increased productivity — and this is a particularly bad trend when combined with high debt levels, which portend the possibility of a future shortage of capital.
Since overall capital investment has already become more restricted and will likely eventually drop significantly since it is not justified by rates of return, China will have to rely more on productivity growth to sustain high rates of economic growth. But productivity is falling and, indeed, the likely future development of the Chinese economy portends further declines in productivity growth, at least in the short term.
The shift of labor from highly unproductive subsistence-oriented agriculture to industry has slowed as large elements of the past rural population has already made this transition. Moreover, as the Chinese economy matures, and as more protectionist trade regimes rise in the world, more Chinese investment will find its way into services rather than manufacturing — and services tend to be inherently less prone to high productivity growth than manufacturing.
All signals seem to point to a much lower growth future for China, unless it is able to dramatically shift its consumption away from low productivity and often money losing infrastructure investment to consumer consumption and, even then, to supercharge these services with an enhanced competitive atmosphere in which state companies and highly indebted local governments play a less formidable role and independent entrepreneurs play a much greater role. However, the large state companies and local governments form much of the base of support for the Communist Party and this shift is unlikely to occur in the current political environment of China. The emergence of a low growth China seems a likely outcome.