The inevitable Chinese slowdown My weekly column

Growth in China slowed again in 2018, with an average of 6.6% across the year vs. 6.9% in 2017. This remains a respectable figure, but it is the lowest since 1989 and 1990 as shown in the chart opposite. The 10-year average is also at a low, at around 8%. The 10% that had previously been typical of the Chinese economy is now a thing of the past, and expectations of a shift back to this trend are unrealistic. The Chinese economy is changing, setting the stage for a slower pace of growth. 

A weighty challenge for the world as a whole

Slowing Chinese growth often sets off the warning bells on world growth as a whole. Having hinged on developed countries during the period after the Second World War, growth is now dependent on the situation in China, which has displayed exceptional expansion since the start of the 1990s, creating strong and long-lasting impetus for the world overall.

The world growth driver is now China, rather than developed markets, and this shift is particularly vital as potential growth in developed countries has been on the wane since 2008. Right across the globe, from the US to France, growth that can be sustained in the long term while not generating permanent imbalances is weaker than before the 2007 crisis, and none of these countries can drive strong and self-sustaining growth from within their borders. Meanwhile, China managed to fuel momentum, taking over the role of developed economies – particularly the US – and benefiting the entire world economy. So China managed to set the stage for stronger growth the world over on a long-term basis, either by sparking fresh competition on the Western markets, developing relationships with other emerging countries (Asia, Africa, Latam) or attracting capital to take advantage of Chinese growth, even if the price to pay for this was the transfer of technology.

According to IMF data (in current dollars terms), Chinese GDP has gone from less than 2% of world GDP in 1991 to 6% ahead of the 2007 crisis and then 16% in 2018, reflecting an astounding acceleration and putting it on a par with the euro area. Chinese GDP as measured in purchasing power parity – a more coherent price and exchange rate system than the dollar-denominated assessment – has been higher than the US figure since 2014 and above the euro area figure since 2011.

More generally speaking, an increase in the weighting of China was achieved primarily at the expense of Europe and Japan, while the US maintained its strong representation. This also explains why the tension surrounding technological leadership is a Chinese-US matter and excludes Europe, which was not sufficiently involved in supporting China’s swift development.

A final point worth keeping in mind is that Chinese imports equated to close to 80% of US imports in 2017. A domestic Chinese shock affecting its imports would have a similar effect to a shock on US domestic demand and hence on its imports, and the worldwide impact of a shock on Chinese growth would be closer than many would expect to the effects of a shock on US growth.

Growth will continue to slow

The Chinese economy’s growth is bound to slow, partly as a pace of 10% is not sustainable in the long term, and also as the very structure of the country’s growth is changing. The Chinese economy previously relied on industry, but now it is more driven by services. However, productivity for services is weaker than for industry, and this change is dragging growth down. The Chinese population enjoyed an improvement in their situation but at the cost of considerable efforts in industry. They now have higher income and are looking to address other needs i.e. healthcare, education, leisure, etc.

The chart shows the weighting of different sectors in Chinese growth since 1952 and their changes, with the contribution from industry remaining very high and steady until 2011. This was when China turned its gaze outwards to the world via massive investment and a focus on exports at any cost, while consumption was relegated to second place.

The change driven by Xi Jinping on the development of the domestic market and on consumption went alongside the expansion of the proposition of services in Chinese GDP, now accounting for more than 50% of economic activity.

The slowdown in Chinese is a result of this structural change as services display weaker productivity than industry, but this shift is not just specific to China. France underwent a similar trend in the 1970s with the transition from industry to services, pushing the country’s economic growth down from close to 6% at the end of the 1960s to 2% at the start of the 1980s.

With the increased weighting of services, we should expect the pace of growth to fall below 5% in the relatively near future. However, this figure will remain high as Chinese authorities do not want to abandon industry in the near future.

The "Made in China 2025" program and the "Belt and Road Initiative" are primarily aimed at promoting technological development and innovation on the one hand and then distributing these products to the rest of the world on the other.

New world balance needs to be found

Chinese determination to maintain strong industrial power limits other industrialized countries’ ability to take back control over this sector. The chart opposite shows that the industrial balance has changed.

Over the past ten years, output from the industrialized countries that drove growth after WW2 has been flat at best, with the US gaining 5% in 10 years, while the euro area shed 3% and Japan lost 12%. However, Asia excluding Japan (mainly China) saw a twofold increase in activity over the period, marking a real watershed. 

Before the crisis in 2007, there was an auspicious wave of globalization when the world economy tended to specialize along geographical lines, as each country made the most of its comparative advantage to focus on the most beneficial business for its particular circumstances. Industry therefore moved towards Asia while at the same time developed countries focused on services. This balance worked well for a while as some countries designed while others – mainly China – assembled.

This set-up shifted as China moved from its role as assembling country to designer, so developed markets’ previous advantage disappeared, and this laid the foundations for the tension between the US and China. If China has the wherewithal to design products and then manufacture them, then it can decide what standards are used in the various technologies, affording it a considerable advantage over competitors, and particularly US companies.

The other aspect worth keeping in mind is that factories and expertise in the production and assembly of manufactured products are located in Asia – especially in China – and this geographical specialization would be very expensive to change.

So China is going to have a major comparative advantage over the years ahead even if it displays lower trend growth.

Short-term momentum is tougher

The structural change mentioned above has an instant impact on short-term momentum. The greater role for services reflects the choice to let growth be driven moreso by the domestic market, so consumption was favored to the detriment of investment, which had been very high for a very long term to help export more, but must now be cut back.

This is the challenge that will shape the Chinese economic landscape. Investment as a percentage of GDP must be cut back to transfer resources to consumption and services and lay the groundwork for more balanced growth. The old model is no longer effective as very high investment no longer guarantees a strong and sustainable external surplus for the Chinese economy, as shown on the chart.

Despite a radically changing economy, the weighting of investment is now excessive.

So this raises questions on the effectiveness of this investment with lower yields, surplus capacity and a more tricky financial balance to boot, as investment was financed via debt. This whole series of factors put together is worrying as companies have continued to invest as before even if this led to surplus capacity and lackluster margins. The key was the ability to find funding.

The change took place in 2009 after the world recession, when the authorities made moves to drive economic activity by setting up lending facilities for companies. The system depended heavily on local authorities with the risk of leading to excesses, particularly for public companies. This momentum continued, while at the same time greater funding came from shadow banking. So the authorities’ aim now is to normalize investment while also normalizing funding, i.e. getting a better grip on financing set-ups, while limiting the risk of an economic collapse and corporate defaults. 

Efforts to get shadow banking under control are reflected in lending figures from this sector, and the central bank is beginning to restrict this type of funding (thank you for the chart Zouhoure Bousbih). The aim is to better control funding and eliminate lending to zombie companies i.e. those that can survive only as a result of unregulated financing. The central bank is on a knife-edge on this issue as it has to act to help finance the economy, while steering economic growth to avoid debt default and the risk of a collapse that would drag down the entire system.

Generally speaking, these transition phases are always chaotic, with a shift from one situation to another with varying degrees of progress on varying issues, so the role of economic policy is to facilitate these changes. This involves very active monetary policy with virtually constant adjustments to financial conditions, while fiscal policy has become very accommodative with significant tax cuts in 2018 and 2019 for companies – in particular small companies – as well as households. This obviously translates into a deterioration in the budget balance, but this is vital to support the transition and share out the cost over time.

So economic trends are poised to settle on a path of slower growth with more severe fluctuations in the short term. There is the risk that the Chinese economy will suffer a crisis and that growth will plummet as the transition is too severe. Economic policy has worked to rule out this type of situation in the past and I continue to believe in the effectiveness of economic policy.

High political risk

There are several other risks to remember in the Chinese economy.

The first is that during this transition phase, public companies, which are generally very large, will do whatever it takes to safeguard their business and their funding to the detriment of private sector companies. These large public companies are still in a powerful position, with a considerable political dimension due to their ties with local public authorities. This is a key challenge as public companies are not renowned for their profitability and agility, whereas the private sector has shown that it is adaptable, efficient and profitable. Any crowding-out of the private sector would be disastrous.

However, we cannot rule out this risk. During the festivities to celebrate the 40th anniversary of Deng Xiaoping’s reforms in December, a change seems to have been witnessed on the roles of the State and the market. Deng Xiaoping’s reforms helped open the Chinese economy and made it more open to market signals to drive economic activity. Yet during these celebrations, there was something of a feeling of a return to a greater State influence, with the return of a strategist State to the detriment of market signals. This is a risk: if the situation were to develop in this way, public companies would regain some influence in decision-making processes. Centralized decision-making has never been truly efficient in the long term. This would mean a great risk for China and its influence on the rest of the world.

Furthermore, a State that ignores market signs means a risk of legal uncertainty, and in this type of situation, there is no guarantee that the State would not change the rules when it suits it – this is standard behavior in developing countries. But this would be disastrous for all investors and we would like to think that the Chinese authorities have moved beyond this type of approach.

Alongside this change in economic and technological leadership, there is also political leadership. For the moment, the US still has considerable headway over the rest of the world, but this may only be temporary due to the swift increase in China’s defense spending, and this is the first step towards a change in political balance. The world would then tilt towards Asia.

The third risk is the threat of confrontation with the US. The White House’s moves to restrict trade between China and the US first and foremost reflect a question of innovation leadership. After catching up with the US on a range of technologies, China is starting to move ahead in areas such as 5G and artificial intelligence. This is a vital point as this ability to innovate further is what could help China become the world economic leader. China wants to step up its leadership, and the "Made in China 2015" and "Belt and Road Initiative" are definite moves in this direction. This means that the battle of wills is set to continue with the US and will obviously create short-term volatility.

China had seen a long period of Great Divergence as it failed to take part in the European industrial revolution in the 19th century, but is now converging very fast with the risk that this shift will be to the detriment of western countries. China would then regain its title as the largest economy in the world.