China economy update - December edition

This is the third in the series on China's economy. The first two are here and here. 

Brad Setser points to two contesting mainstream arguments on China's ongoing economic problems. Adam Posen et al argues that it's the centralisation and dismantling of the balance between the state, the party and the market that is the real problem. Michael Pettis et al believe that it's the continuing structural imbalance in the economy - excessive investment in infrastructure crowding out private consumption - that's the real problem. 

I'm inclined to the view that both are responsible, with the former also worsening the problems from the imbalances, and the pandemic becoming the trigger for the edifice to give way. Two graphs in particular are important. China's savings rate has actually increased during the pandemic

And the country saw the highest decrease in private consumption among all major economies

Brad Setser writes,

China's strong growth amid a structural glut of savings and limited household demand always depended on its ability to sustain turbo-charged rates investment. But investment now appears to be falling back toward more reasonable levels – the recent crisis among China's property developers illustrated clearly that China has too many apartments relative to underlying demand. Household construction is expected to fall to 50 or 60 percent of its previous levels. Absent an alternative growth engine, China’s economy inevitably will slow, and potentially slow sharply. Xi's policies haven't helped, but China was headed towards a slowdown linked to a correction in excessively high levels of investment in real estate even if Xi had shown more interest in the old reform and opening up agenda... 

China’s banks, trusts, and other financial institutions have lent huge sums to China’s property developers, to households looking to buy apartments, and to local governments building public infrastructure even as China’s big policy banks financed construction projects around the world as part of its Belt and Road Initiative. China’s financial system could do both kinds of lending without borrowing large sums from the rest of the world, thanks to the country’s enormously high domestic savings rate, which has averaged about 45 percent of its GDP over the last 20 years … Saving is often considered a virtue and the absence of significant external debt gives China more options for managing the current property slump ... But too much saving helped create China’s current financial difficulties, as it fostered an economic environment where China’s rapid growth effectively required increasing domestic debt.

Michael Pettis puts China's structural imbalances in a global perspective

Investment accounts for roughly 24 per cent of global gross domestic product, and consumption the remaining 76 per cent. Even in the highest investing economies, the actual investment share of GDP rarely exceeds 32-34 per cent, except for short periods of time. China, however, is an extreme outlier. Investment last year accounted for around 43 per cent of its GDP, and has averaged well over 40 per cent for the past 30 years. Consumption, on the other hand, accounts for roughly 54 per cent of China’s GDP (with its trade surplus making up the balance). 

Put another way, while China accounts for 18 per cent of global GDP, it accounts for only 13 per cent of global consumption and an astonishing 32 per cent of global investment. Every dollar of investment in the global economy is balanced by $3.2 dollars of consumption and by $4.1 in the world excluding China. In China, however, it is offset by only $1.3 of consumption. What is more, if China were to grow by 4-5 per cent a year on average for the next decade, while maintaining its current reliance on investment to drive that growth, its share of global GDP would rise to 21 per cent over the decade, but its share of global investment would rise much more — to 37 per cent. Alternatively, if we assume that every dollar of investment globally should continue to be balanced by roughly $3.2 dollars of consumption, the rest of the world would have to reduce the investment share of its own GDP by a full percentage point a year to accommodate China.

He points to the less discussed external constraints on the sustainability of such investment driven economic growth model, even if the investments shift from real estate to manufacturing as appears to be happening.

Is that likely? Probably not, given that the US, India, the EU and several other major economies have made very explicit their intentions to expand the role of investment in their own economies. But without this kind of accommodation from the rest of the world, any major expansion in China’s share of global investment risks generating much more global supply than demand. That will be especially painful for low-consuming economies, that will be competing producers, even perhaps for China itself...

But if China’s share of global GDP rises over the next decade, driven by a continued reliance on manufacturing, how easily can the rest of the world absorb the country’s expansion? Currently, the manufacturing sector globally comprises roughly 16 per cent of the world’s GDP, and as little as 11 per cent of the US economy. China is once again an outlier, with a manufacturing share of GDP at 27 per cent, higher than that of any other major country. If its economy were to grow over the next decade at 4-5 per cent a year even without a further increase in the manufacturing share of the country’s GDP, China’s share of global manufacturing would rise from its current 30 per cent to 37 per cent. Can the rest of the world absorb such an increase? Only if it is willing to accommodate the rise in Chinese manufacturing by allowing its own manufacturing share of GDP to decline by half a percentage point or more... China cannot raise its share of global GDP without an accommodation from an increasingly reluctant rest of the world. Without that contentious accommodation, the global economy would find it extremely difficult to absorb further Chinese growth.

In a reflection of the depressed consumer expectations, the Times points to the rise of thriftiness and bargain hunting among Chinese consumers. This has led to price wars to the bottom among brands. 

Underlining the extent of problems facing the Chinese property market, more than half of top 50 developers have gone into default!

Property sales have plunged for the top 10 developers

This is a stunning statistic

Chinese developers have defaulted on around $115bn of $175bn in outstanding offshore dollar bonds since 2021.

Compounding the worries of credit squeeze is the fact that developers still have to complete large volumes of property and deliver them to buyers, many of whom have already paid a major part of the price. 

Pettis has a good summary of the impact of the real-estate bubble driven crisis facing the financial system in China, 

Over the past 2-3 decades a huge amount of fictitious wealth was created, with most bank, business, household and government balance sheets, and a great deal of economic activity, being organized around this "wealth" creation. As it increasingly disappears, all these balance sheets must adjust, and a great deal of economic behavior must now organize itself around minimizing the cost of ultimately absorbing the losses. This process is what creates and spreads financial distress. Rather than try to prevent the contraction in prices, Beijing regulators would do better in the long term to reduce their financial distress impacts by making clear which sectors of the economy will ultimately be forced to absorb the losses.

And this stress has spread wide across the financial system and the economy. Foreign direct investment in China has plunged to a two-decadal low.

On the same lines VC inflows to China has dived tenfold from nearly $50 bn in 2021 to about $5 bn in 2023. 

The growing pile of problems are having its political impact. FT has a long read that points to the fraying of the social contract between the Communist Party and the citizens. 

The Communist party used to allow its people abundant economic opportunity in exchange for heavy restrictions on their political freedom. Now the so-called social contract is no longer clear. In the place of growth and opportunity are vague promises of security and “a better life”. But with about 600mn people struggling to get by on less than $140 a month, will that be enough? A once optimistic society now worries about the future. “The old contract was a pretty simple one which is: ‘We’ll stay out of politics, we won’t express sensitive opinions, provided we can expect to be prosperous in the future’,” says George Magnus, author of Red Flags: Why Xi’s China is in Jeopardy, and a research associate at the University of Oxford’s China Centre. That “has been undermined and not just by the fact that China’s old development model is not really working anymore but also by the government’s own culpability for not addressing the issues,” he says. “Fundamentally, it’s an issue of trust.”

.... After securing his second term as party secretary at the 19th party congress in 2017, Xi signalled a “new deal” for China... Xi declared China was facing a new challenge. After decades of rapid growth, he said the “principal contradiction” was “between unbalanced and inadequate development and the people’s ever-growing needs for a better life”. These “needs”, he said, included “demands for democracy, rule of law, fairness and justice, security, and a better environment”. Security was the keyword, analysts say. When Xi became party leader in 2012, the organisation was concerned that the growing private sector was empowering entrepreneurs and eclipsing the apparatchiks. In 2013, the party circulated an internal memo, Document Number Nine, attacking western constitutional democracy and other ideas, such as universal human rights and ardently pro-market “neoliberalism”. In the ensuing years, Xi has rooted out dissent and enforced party discipline through endless anti-corruption campaigns while pursuing a more assertive foreign policy, alienating large trading partners such as the US... This tightening of control is pervasive, from limits on the publication of economic data and investigations of foreign consultancies under data and anti-espionage laws, to the detention of a million Uyghurs in Xinjiang and the sinicisation of religion and culture, analysts say...

But it was in 2021, as the economy was recovering from the first shock of the onset of Covid-19, that Xi launched one of his most decisive campaigns yet to meet the people’s aspirations for a “better life” — what he called “common prosperity”. Beijing cracked down on the internet empire of billionaire Jack Ma, leading him to largely disappear from public, and the country’s other important internet groups, shutting down overnight the whole industry of online tutoring and restricting online gaming for children. In a speech on common prosperity at the party’s central committee for financial and economic affairs in August 2021, Xi expounded on the policy’s deeper aims. Cadres must “resolutely oppose the unlimited sprawl of capital” and “uphold the dominant role of the public sector”, he said, while also somehow mobilising “the zeal of entrepreneurs”. Tellingly, this was not a call for a European-style social welfare state. The party was pursuing its long-term strategic objectives of building China “into a great modern socialist country”, he said, but it must not “fall into the trap of ‘welfarism’ that encourages laziness”.

This about the rural-urban divide is interesting

China’s average annual pension per head for urban residents was Rmb50,763 ($6,936) in 2021, about 22 times the rural equivalent, while civil servants received Rmb77,804. The average annual healthcare disbursements for urban residents in 2021 totalled Rmb4,166, about 4.4 times the rural equivalent.

The article links to a blog post by Bert Hoffman, a previous World Bank China Country Director, who lists out a series of reforms that Beijing needs to do.

Martin Sandbu points to the stark disparity in the progress of the lives of the bottom half of the population compared to the top 10%, a divide that has ballooned spectacularly since the turn of the millennium!

Finally, Ruchir Sharma presents some striking facts about the world of post-peak China,

In nominal dollar terms, China’s GDP is on track to decline in 2023, for the first time since a large devaluation of the renminbi in 1994... Its share of the global economy rose nearly tenfold from below 2 per cent in 1990 to 18.4 per cent in 2021. No nation had ever risen so far, so fast. Then the reversal began. In 2022, China’s share of the world economy shrank a bit. This year it will shrink more significantly, to 17 per cent. That two-year drop of 1.4 per cent is the largest since the 1960s... To put this in perspective, the world economy is expected to grow by $8tn in 2022 and 2023 to $105tn. China will account for none of that gain, the US will account for 45 per cent, and other emerging nations for 50 per cent. Half the gain for emerging nations will come from just five of these countries: India, Indonesia, Mexico, Brazil and Poland...

China’s real long-term potential growth rate — the sum of new workers entering the labour force and output per worker — is now more like 2.5 per cent. The ongoing baby bust in China has already lowered its share of the world working age population from a peak of 24 per cent to 19 per cent, and it is expected to fall to 10 per cent over the next 35 years. With a shrinking share of the world’s workers, a smaller share of growth is almost certain.

Sharma's argument is that for sometime now Beijing has manipulated its real GDP growth by playing around with the inflation rate.