As China’s economy has struggled to gain traction this year, many investors accept that its economic growth rate will be below the government’s official target of 5 percent. This is reflected in a significant underperformance of China’s stock market relative to the U.S. and other global peers in the past four months. During August, foreign investors sold Chinese shares at a record pace according to the Financial Times.
There is currently a diversity of views about China’s economy. Until recently, most forecasters anticipated that China could sustain 5 percent growth throughout this decade. However, the IMF now puts China’s GDP growth at below 4 percent in coming years. The Lowy Institute, an Australia-based think tank that conducts research on the Asia/Pacific region, offers a more pessimistic prognosis: It projects that growth will slow to 3 percent by 2030 and average 2%-3% per annum over the next two decades.
This begs the question of how China can attain its stated 5 percent goal. There is widespread agreement that the country’s population is peaking and is about to decline as a result of the former one-child policy. The main engine of growth has been the country’s high rate of capital formation, which is supported by a high saving rate. However, returns on capital have fallen owing to diminishing returns, and overall economic efficiency as measured by growth of total factor productivity has been cut roughly in half in the past decade. Therefore, economic efficiency would have to improve significantly to achieve the stated target.
Many economists question how this will be possible. Economic policy under Xi Jinping has favored inefficient state-owned enterprises over the private sector, which is the main source of the country’s innovation and dynamism. There has also been an excess of public infrastructure in many areas, and the property sector is now under severe strain following decades of over-building that will take years to unwind. Meanwhile, the government is constrained from boosting spending by China’s high debt ratio that is approaching 300 per cent of GDP.
Mickey Levy of Berenberg Capital Markets contends that it would be prudent for China’s leaders to acknowledge these challenges and to set a more realistic growth target of 2-3 percent in the intermediate term: “Trying to achieve a higher target would require significant fiscal stimulus and government investment in unproductive activities that would primarily serve to lower future potential growth.”
If so, investors will need to consider the ramifications if China’s trend growth rate is cut roughly in half. The potential impact on the global economy should not be dismissed, considering that China along with the U.S. have been the primary engines of global growth since China became a member of the World Trade Organization in December of 2001. JPMorgan estimates that China’s contribution to global growth doubled from 15 percent in the first decade of this century to more than 30 percent in the second decade.
Following are key areas that are likely to be impacted by a sustained Chinese slowdown:
First, the most adversely affected are emerging economies that produce commodities and raw materials, because China is a major importer of these items. This already is apparent in emerging market equities, which experienced their worst monthly returns in August since 2015. As China reduces its reliance on the property sector, which absorbs tons of iron ore from Brazil and Australia, it is also likely to play a less prominent role in the global industrial cycle.
Second, the region that faces the most direct impact is the Asia/Pacific as it is the most closely integrated with China. Therefore, it could experience a growth slowdown. However, there are several offsets that will help to support some countries over the longer term. One is that multinational corporations have been diversifying their supply chains away from China as a result of the Covid-19 pandemic and heightened tensions between the U.S. and China. Among the main beneficiaries are India, Japan and Vietnam, which have been able to attract sizable foreign direct investment flows.
Third, trade flows between the U.S. and China, which have already been impacted by frictions between the two countries, could diminish further. This could have an impact on U.S. economic growth. However, should China’s crisis spread, Paul Krugman observes that America has “remarkably little financial or trade exposure to China’s problems.” Another potential offset is that deflationary pressures in China could help alleviate inflation in the U.S. and other industrial countries, and thereby help to lower interest rates.
One issue that some observers have raised is whether China will experience a “lost decade” similar to Japan’s after its real estate and stock market bubbles burst.
My take is that while there are some parallels between the two countries, there are also several key differences. One is that the magnitude of the decline in property values in China is likely to be less severe than in Japan, which experienced a cumulative decline of about 70 percent. The policy response is also very different, with China continuing to prop up the market whereas the Bank of Japan tightened monetary policy with the intent of bursting the bubble. Furthermore, China’s banking system is less at risk than Japan’s was because it is primarily state-owned.
Weighing these considerations the most likely outcome is that China’s economic slowdown will be less abrupt than Japan’s. But it will also take a long time for excesses that have been created to be worked out.
Meanwhile, Chinese corporations’ average return on assets has fallen steadily both for privately-owned and state–owned enterprises since the mid-2010s. Consequently, even though China’s stock market may appear cheap with a low P/E ratio, it could continue to lag global peers for some time because investors have not priced in a sustained economic slowdown. In these circumstances, global investors may routinely underweight Chinese stocks relative to their benchmarks just as they did for Japanese stocks during the period when its bubble burst.
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