Will China still be the engine of the world economy?
China's current recovery is taking a completely different form. Not only is the country experiencing diminishing returns from its investment-led model, but it is also facing the end of the export boom linked to the global bloc. The analysis of Gerwin Bell, Lead Economist for Asia of the Global Macroeconomic Research team of PGIM Fixed Income.
China's traditional method of stimulating growth when needed or desired (for example, after the 2008 global financial crisis) has had knock-on benefits throughout the global economy. China has opened the credit tap to stimulate public and private investments, the latter particularly concentrated in the real estate sector. Hard commodities and the capital goods needed to support these investments have consequently given a boost to exporters of commodities, such as Chile, Brazil and Australia, and of capital goods, such as those of Germany and Eastern Europe.
China's current recovery is taking a completely different form. Not only is the country experiencing diminishing returns from its investment-led model, but it is also facing the end of the export boom linked to the global bloc. As a result, the recovery will increasingly rely on Chinese consumers. However, recent data shows that the recovery in real retail activity is already stalled and still far below its pre-2020 trend – the exact opposite of the US recovery. This contrast is not surprising given that Chinese consumers have received far less stimulus support than US or European households and their limited resources underscore the tainted state of China's current recovery.
THE GLOBAL EFFECTS
The modest increase in China's consumption activity has been accompanied by a moderation in its traditional investment indicators, such as demand for hard commodities, including copper, iron ore and cement, and in trade activity with Europe.
While Chinese consumers may provide some support for crude oil and food commodities, their focus on real estate investments may have run its natural course. After years of emphasis, Chinese households own the most properties on an international comparative basis, and as a result, the country's real estate market has become the most expensive in the world. Given the sustainability issues arising from these real estate dynamics, Chinese authorities cracked down on overleveraged real estate investors as part of their “Three Red Lines” policy during the height of the pandemic. This timing likely exacerbated the massive shock that hit the industry across the country, taking a toll on consumers' perceptions of wealth and shattering their concept of property as a store of value. In turn, startup housing has declined sharply, performing far worse than the US housing market, posing an ongoing concern for investors.
Looking at the background of events, the Chinese authorities launched an initiative at the October 2022 Communist Party Congress to revive the sector with various incentives. However, this has only resulted in temporary improvements at the margins (for example, the completion of already started buildings) and demand already seems to be weakening in the middle of the still ongoing year. China's housing market is unlikely to receive significant support from the labor market, which has deteriorated significantly, especially for young people and college graduates. Indeed, the youth unemployment rate has soared to an all-time high of over 20% – this is before more than 10 million new college graduates enter the job market in late summer 2023.
WHY NOT USE THE PROVEN METHOD?
The above points raise the question of why China does not return to the tried and tested methods of economic recovery. In general, the low returns and increasing risks of these methods have made the authorities reluctant to pursue them. Starting from the macro level, repeatedly flooding the economy with credit, China has placed itself in a cyclical debt dilemma. A debt/GDP ratio of around 300%, with an average interest rate of around 5%, produces an annual interest expense equal to 15% of GDP, against a nominal GDP growth rate of the country of recently it has been 6%-8%. Thus, from a fundamental credit perspective, China's annual interest expenditure is twice its organic GDP growth: it's never a pretty story when a borrower has to take on more debt just to pay the interest.
However, China's medium-term growth factors appear increasingly weak, as they consist of excess manufacturing capacity and deteriorating demographics in the presence of a rapidly aging population. One way to evaluate these growth drivers is total factor productivity, which is how effectively a country uses its resources to generate growth. This measure has decreased rapidly in China over the past 10 years.
As the main drivers of China's medium-term growth weaken, our 2024 GDP forecast points to a moderation at 4.5% that is likely to continue. Over five years, the country's growth could approach its potential, slightly below 4%, and then reduce to less than 3% over the next 10 years.
As far as the geopolitical sphere is concerned, the growing tensions between China and the United States certainly play a part in our vision. Developments in the South China Sea provide an example of why we don't see conditions improving anytime soon. While the Chinese leadership views the country as an emerging global power – returning to a position it occupied in the pre-industrial era – this projection is evident regionally in naval expansion and island building in the South China Sea, which is an important of global navigation. However, the United States and its regional allies continue to oppose this expansion. These non-aligned viewpoints – China's belief in its right to strengthen its regional presence and US intentions to uphold post-World War II international norms – are behind the escalation of tensions.
In an economic context, geopolitical tension is highlighted by the growing technological gap between China and much of the developed world, which is increasingly hesitant to share progress and data with China. While China is an important market, the gap exposes China to the risk of becoming a technology and data island, with the related implications for growth.
CONCLUSIONS
As debate and uncertainty about the direction of the global economy continue, China will no longer be the engine of growth that will lift the world economy at large out of any stagnation. Indeed, in the medium term, the weakening of fundamentals and the emphasis on domestic consumption could lead to a growth rate that rapidly converges with the developed world.
This brings us to two further points where we would expect less change, contrary to what is held by much of public opinion. The first is the idea that near-offshoring initiatives are on the verge of drying up Chinese manufacturing demand. While there is excess manufacturing capacity, China's economic structure has made it the world's factory and this will not unblock itself quickly. Those who point to other manufacturing bases, such as Vietnam or Mexico, that may see increased manufacturing demand will consequently need to import more components from China to meet that demand.
The second point concerns the prospect that, over time, the Chinese yuan will replace the US dollar as the world's reserve currency. But for a currency to do that, capital must circulate freely. The measures that China will have to take to manage its debt load – in particular the reduction of interest rates, with the consequent resistance of the yuan – require capital controls, to prevent capital flight from becoming an ever more tangible risk . Indeed, China's capital account is tightly controlled, which is not something global investors are used to, or want, when deploying capital overseas. Therefore, for the foreseeable future, the yuan poses no threat to the primacy of the dollar, especially if China's recovery takes a different shape than in the past.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/la-cina-sara-ancora-il-motore-economia-mondiale/ on Sun, 09 Jul 2023 05:51:52 +0000.